Question

Blitz Industries has a debt-equity ratio of 1.1. Its WACC is 7.3 percent, and its cost of debt is 5.1 percent. The corporate tax rate is 21 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. Debt equity Ratio =1.1
Debt Ratio =1.1/2.1
Equity Ratio =1/2.1
Equity Cost of capital*Weight of Equity+Cost of Debt*Weight of Debt*(1-Tax Rate) =WACC
1/2.1*Cost of Equity+1.1/2.1*5.1%*(1-21%) =7.3%
Cost of equity =(7.3%-1.1/2.1*5.1%*(1-21%))*2.1 =10.8981% or 10.90%

b. Cost of levered equity =Cost of unlevered equity+(1-Tax rate)*Debt/Equity*(Cost of unlevered Equity-Cost of debt)
10.8981% =Cost of unlevered equity+(1-21%)*1.1*(Cost of unlevered equity-5.1%)
Cost of unlevered equity =(10.8981%+0.79*1.1*5.1%)/(1+0.79*1.1)=8.20224719% or 8.20%

c-1. Debt-equity =2
Cost of levered equity =Cost of unlevered equity+(1-Tax rate)*Debt/Equity*(Cost of unlevered Equity-Cost of debt)
=8.20224719%+(1-21%)*2*(8.22024719%-5.1%) =13.10%

c-2. Debt-equity =1
Cost of levered equity =Cost of unlevered equity+(1-Tax rate)*Debt/Equity*(Cost of unlevered Equity-Cost of debt)
=8.2022%+(1-21%)*1*(8.2202%-5.1%) =10.65%

c-3.Debt-equity =0
Cost of levered equity =Cost of unlevered equity+(1-Tax rate)*Debt/Equity*(Cost of unlevered Equity-Cost of debt)
=8.2022%+(1-21%)*0*(8.2202%-5.1%) =8.20%