Blue Bull, Inc., has a target debt-equity ratio of .82. Its WACC is 8.6 percent,

Question

Blue Bull, Inc., has a target debt-equity ratio of .82. Its WACC is 8.6 percent, and the tax rate is 30 percent. Required: (a) If the company?s cost of equity is 12.2 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).) (b) If the after tax cost of debt is 5.3 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).)

Explanation / Answer

Solution:

WACC = we re + wp rp + wd rd (1-tc )

The debt to equity ratio is 0.82 which means the proportion of debt is 82% and proportion of equity is 18%

a) re = 12.2%

0.086 = 0.18X0.122 + 0.82 X rd

0.086 = 0.02196 + 0.82 X rd

rd = 7.80% ( Pretax cost of debt)

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b) 0.086 = 0.18 X re + 0.053

re = 18.33 % ( Cost of equity)

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