Question

Sullivan Company, which is currently all-equity, has a cost of equity of 8%. Sullivan plans to change its capital structure such that its capital structure would consist of 30% debt and 70% equity. In order to make this change, Sullivan would issue debt and use the proceeds to purchase back an equivalent amount of equity. Sullivan’s before-tax cost of debt is 6%. Its marginal tax rate is 35%. The cash flows are assumed to be perpetual.

Based on MM propositions with corporate taxes, Sullivan’s cost of equity after the capital structure change is closest to:

a. 8.0%
b. 8.6%
c. 8.8%

Answer 1

Based on MM propositions with corporate taxes, Sullivan’s cost of equity after the capital structure change can be calculated in following manner -

Cost of equity (levered equity, after the capital structure change)

= return (unlevered equity) + [return (unlevered equity) – return (debt)] * (1 – tax rate) * (D / E)

Therefore,

Cost of equity (levered equity, after the capital structure change)

= 8% + (8% – 6%) * (1- 35%) * (30%/70%)

= 8% + 2% * 0.65 * (3/7)

= 8% + 0.56%

= 8.56% or 8.6%

Sullivan’s cost of equity after the capital structure change is closest to 8.6%

Therefore correct answer is option b. 8.6%