Question

Problem 12-14 WACC [LO 3] Blue Bull, Inc., has a target debt-equity ratio of .80. Its WACC is 8.4 percent, and the tax rate is 35 percent. Required: (a) If the company's cost of equity is 12 percent, what is its pretax cost of debt?(Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) Pretax cost of debt (b) If the aftertax cost of debt is 5.1 percent, what is the cost of equity? (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) Cost of equity

Answer 1

Debt-equity ratio=debt/equity

Hence debt=0.8*equity

Let equity be $x

Debt=$0.8x

Total=$1.8x

WACC=Respective costs*Respective weight

a.

8.4=(x/1.8x*12)+(0.8x/1.8x*Cost of debt)

8.4=6.67+(0.8/1.8*Cost of debt)

Cost of debt=(8.4-6.67)*1.8/0.8

=3.9%

Pre-tax Cost of debt=Cost of debt/(1-tax rate)

=3.9/(1-0.35)

=6%

b.

8.4=(0.8x/1.8x*5.1)+(x/1.8x*Cost of equity)

8.4=2.267+(x/1.8x*Cost of equity)

Cost of equity=(8.4-2.267)*1.8

=11.04%