Question

Blitz Industries has a debt-equity ratio of 1.5. Its WACC is 8.3 percent, and its cost of debt is 5.9 percent. The corporate tax rate is 25 percent.

  

a.	What is the company’s cost of equity capital? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
b.	What is the company’s unlevered cost of equity capital? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c-1.	What would the cost of equity be if the debt-equity ratio were 2? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c-2.	What would the cost of equity be if the debt-equity ratio were 1.0? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c-3.	What would the cost of equity be if the debt-equity ratio were zero? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

     

Answer 1

a)
After tax cost of debt = Before tax cost of debt * (1 - tax rate)
= 5.9% * (1 - 0.25)
= 4.425%

Weight of debt = D/E / (1 + D/E) = 1.5 / (1 + 1.5) = 1.5 / 2.5 = 0.60

Weight of equity = 1 - weight of debt = 1 - 0.60 = 0.40

WACC = (cost of debt * weight of debt) + (cost of equity * weight of equity)
8.3% = (4.425% * 0.60) + (cost of equity * 0.40)
8.3% = 2.655% + (cost of equity * 0.40)
cost of equity = (0.083 - 0.02655) / 0.40
cost of equity = 14.11%

Company's cost of equity capital = 14.11%

b)
RE= RU+ (RU– RD)(D/E)(1 – t)
0.1411 = RU + (RU - 0.059) * 1.5 * (1 - 0.25)
0.1411 = RU + (RU - 0.059) * 1.5 * 0.75
0.1411 = RU + (RU - 0.059) * 1.125
0.1411 = RU + 1.125RU - 0.066375
0.1411 + 0.066375 = 2.125RU
0.2075 = 2.125RU
RU = 0.2075 / 2.125
RU = 9.76%

Unlevered cost of equity = 9.76%

c-1)
RE= RU+ (RU– RD)(D/E)(1 – t)
RE = 0.0976 + (0.0976 - 0.059) * 2 * (1 - 0.25)
RE = 0.0976 + 0.05797
RE = 15.56%

Cost of equity = 15.56%

c-2)
RE= RU+ (RU– RD)(D/E)(1 – t)
RE = 0.0976 + (0.0976 - 0.059) * 1 * (1 - 0.25)
RE = 0.0976 + 0.028985
RE = 12.66%

Cost of equity = 12.66%

c-3)

RE= RU+ (RU– RD)(D/E)(1 – t)
RE = 0.0976 + (0.0976 - 0.059) * 0 * (1 - 0.25)
RE = 0.0976 OR 9.76%

Cost of equity = 9.76%