The cost of equity, the weighted average cost of capital, and financial leverage.

Albarval Co. expects its return on assets to be stable at 12 percent, assuming a target capital structure of 80 percent equity and 20 percent debt. Suppose that the firm's borrowing rate is 8 percent, for a wide range of capital structures.

a. Suppose that Albarval does not pay any tax. What is Albarval's cost of equity? What would Albarval's cost of equity be if the target capital structure is 50 percent equity, 50 percent debt? Show that under both capital structures the firm's weighted average cost of capital (WACC) is the same and that it is equal to 12 percent.

b. Suppose now that the firm's tax rate is 40 percent. What is the cost of equity and the WACC under the two capital structures? Why are the cost of equity and the WACC different under the two capital structures?