Question

Georgia Growers has a return on assets of 12.6 percent. The company is currently an all-equity firm but is considering converting to a debt-equity ratio of .4. The pre-tax cost of debt is 7.2 percent. Ignore taxes. What will the cost of equity be if the firm switches to the levered capital structure?

Answer 1

Suppose value of assets = $100

Net income = $100 × 12.60%

= $12.60

Net Income of company is $12.60.

Now assuem debt equity ratio = 0.40

weight of debt = 28.57%

Value of debt = $28.57

Interest on debt = $28.57 × 7.20%

= $2.06

Net income for levered firm = $12.60 - $2.06

= $10.54

Net income of levered firm is $10.54.

Value of equity = $100 - $28.57

= $71.43.

Cost of equity = $10.54 / $71.43

= 14.76%

cost of equity be if the firm switches to the levered capital structure is 14.76%.