Question

SA company is trying to estimate its optimal capital structure. Right now, it has a capital...

SA company is trying to estimate its optimal capital structure. Right now, it has a capital structure that consists of 20% debt and 80% equity, based on market values (its debt to equity D/S ratio is 0.25). The risk-free rate (rRF) is 6% and the market risk premium (rM – rRF) is 5%. Currently the company’s cost of equity, which is based on the CAPM, is 12% and its tax rate is 40%. Find the firm’s current leveraged beta using the CAPM

1.0

1.2

1.4

1.6

Use info above to find the firm’s unleveraged beta using the Hamada Equation

1.0

1.04

1.08

1.2

Use the information for above two question to find, what would be Simon’s new leveraged beta if it were to change its capital structure to 50% debt and 50% equity using the Hamada Equation?

1.0

1.04

1.2

1.67

Lastly, use the question and work above to find what would be Simon’s new cost of equity if it were to change its capital structure to 50% debt and 50% equity using the CAPM?

12.8%

13.6%

14.3%

15.8%

Homework Answers

Answer #1

a). According to CAPM,

Cost of Equity = rRF + [Beta * Market Risk Premium]

12% = 6% + [Beta * 5%]

12% - 6% = Beta * 5%

Beta = 6%/5% = 1.20

So, 2nd option is correct.

b). Unlevered Beta = Levered Beta / [1 + {(D/E)*(1-t)]

= 1.20/[1+{0.25*(1-0.4)}]

= 1.20/[1+0.15] = 1.20 / 1.15 = 1.04

So, 2nd option is correct.

c). Levered Beta = Unlevered Beta * [1 + {(D/E)*(1-t)]

= 1.04*[1+{1*(1-0.4)}]

= 1.04*[1+0.6] = 1.04 * 1.6 = 1.67

So, 4th option is correct.

d). According to CAPM,

Cost of Equity = rRF + [Beta * Market Risk Premium]

= 6% + [1.67 * 5%]

= 6% + 8.3% = 14.3%

So, 3rd option is correct.

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