Blue Bull, Inc., has a target debt-equity ratio of.83. Its WACC is 8.7 percent,

Question

Blue Bull, Inc., has a target debt-equity ratio of.83. Its WACC is 8.7 percent, and the tax rate is 38 percent. Required: If the company's cost of equity is 12.3 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).) If the after tax cost of debt is 5.4 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

The debt/equity = 0.83

D = 0.83 E, If E = 1, Then D = 0.83

Hence weight of equity = We = 1/1.83 = 0.5464

Hence weight of debt = 1-0.5464 = 0.4536

(a) Cost of equity (Re)= 12.3% and WACC = 8.7%

According to WACC equation , WACC = We * Re + Wd * Rd

8.7 = 12.3*0.5464 + Rd*0.4536

1.97928 = Rd*0.4536

Rd = After tax cost of debt = 4.3635%

Pretax cost of debt = 4.3635/(1-0.38) = 7.04%

(b) WACC = We * Re + Wd * Rd

8.7 = 0.5464*Re + 0.4536*5.4

6.25056 = 0.5464*Re

Re = 11.44%

Cost of equity = 11.44%

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