Question

You are currently the CFO of a firm worth $1 billion and you are considering issuing some additional perpetual debt in order to change your firm's capital structure. Your current beta is 0.93 and you currently have $124 million in debt. You are planning to issue $215 million in additional perpetual debt. Your firm faces a 35% corporate tax rate. Given that the current risk free rate is 2.83% and the current market risk premium is 5.11%, what will be the new required return for your firm's equity holders?

Answer 1

Current Capital Structure
Total Worth = $ 1000 Million
Debt = $ 124 Million
Equity = 1000-124 = $ 876 Million
Debt to Equity Ratio = 124/876 = 0.1416

Beta (Unlevered) = Beta (Levered) / [ 1 + (1-T) * D/E]
Beta (Unlevered) = 0.93 / [ 1 + (1-0) * 0.1416]
Beta (Unlevered) = 0.93 / 1.1416
Beta (Unlevered) = 0.8147

New Capital Structure
Total Worth = $ 1000 Million + 215 Million = $ 1215 Million
Debt = $ 124 Million + 215 Million = $ 339 Million
Equity = 1000-124 = $ 876 Million
Debt to Equity Ratio = 339/876 = 0.3870

Beta (Levered) = Beta (Unlevered) * [ 1 + (1-T) * D/E]
Beta (Levered) = 0.8147 * [ 1 + (1-0) * 0.3870]
Beta (Levered) = 0.8147 * 1.3870
Beta (Levered) = 1.13

Risk Free Rate = 2.83%
Market Risk Premium = 5.11%

Required return for your firm's equity holders = Risk Free Rate + Beta*Market Risk Premium
r = 2.83% + 1.13*5.11%
r = 8.60%