Question

Blitz Industries has a debt-equity ratio of 1.6. Its WACC is 7.8 percent, and its cost of debt is 5.5 percent. The corporate tax rate is 21 percent. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

a. What is the company’s cost of equity capital?

b. What is the company’s unlevered cost of equity capital?

c-1. What would the cost of equity be if the debt-equity ratio were 2?

c-2. What would the cost of equity be if the debt-equity ratio were 1.0?

c-3. What would the cost of equity be if the debt-equity ratio were zero?

Answer 1

a)

WACC = 7.8% Cost of debt (rd) = 5.5% Cost of equity (re) = ? Tax rate (T) =21% Debt equity ratio = 1.6 WACC = Wd* rd *(1-T) + We* re Where Wd and we are weight of debt and weight of equity. 0.078 = (1.6/2.6) *0.055 *(1-21) + (1/2.6) *(re) Solving the equation the value of re comes out to be 13.33%

b)

re=r0+ (ro-rd) * (1-t) * (d/e) re = required return on equity ro = required return on equity with zero debt t = tax rate d/e = debt - equity ratio 0.1333 = r0+ (rO- 0.055) *(1-21)*(1.6) 0.1333 =r0 + (r0-0.55)*(1.264) Solving the value of ro, we get 8.96% so the cost of equity when debt is zero is 8.96%

c-1)

re=r0 + (ro-rd) *(1-t) * (d/e) re = required return on equity ro = required return on equity with zero debt t = tax rate d/e = debt - equity ratio sincero is 8.96, then we can calculate cost of equity if debt to equity ratio is 2 2 rdt de 0.0896 0.055 0.21 putting the values in the above formula re 0.144268

c-2)

  

re=r0+ (ro-rd) *(1-t) * (d/e) re = required return on equity ro = required return on equity with zero debt t = tax rate d/e = debt-equity ratio since ro is 8.96, then we can calculate cost of equity if debt to equity ratio is 1 rd t de 0.0896 0.055 0.21 putting the values in the above formula re 0.116934

c-3)

  

re=r0 + (ro-rd) * (1-t) * (d/e) re = required return on equity ro = required return on equity with zero debt t = tax rate d/e = debt - equity ratio since ro is 8.96, then we can calculate cost of equity if debt to equity ratio is 0 de rordt 0.0896 0.055 0.21 putting the values in the above formula 0.0896