Question

Laramie Trucking's CEO is considering a change to the company's capital structure, which currently consists of 25% debt and 75% equity. The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio. The risk-free rate, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm's tax rate is 25%. Currently, the cost of equity, rs, is 11.5% as determined by the CAPM. What would be the estimated cost of equity if the firm used 60% debt?

a. 16.05% b. 11.50% c. 12.50% d. 14.77% e. 13.58%

Answer 1

Given about Laramie Trucking,

Weight of debt Wd = 0.25

Weight of equity We = 0.75

=> D/E ratio = 0.25/0.75 = 1/3

Risk free rate Rf = 5%

Market risk premium MRP = 6%

Tax rate = 25%

Current Cost of equity rs = 11.5%

So, Beta at current level of equity using CAPM is

Beta = (rs - Rf)/MRP = (11.5 - 5)/6 = 1.0833

So, unlevered beta of the firm using current structure is

B(unlevered) = B(levered)/(1 + (D/E)*(1-T) = 1.0833/(1 + (1/3)*(1-0.25)) = 0.8667

Under new capital structure, Weight of debt = 60%

=> D/E ratio = 0.6/(1-0.6) = 1.5

So, Beta (levered) for this capital structure is

B(levered) = B(unlevered)*(1 + (D/E)*(1-T)) = 0.8667*(1 + 1.5*(1-0.25)) = 1.8417

So, using this beta, cost of equity is

rs = Rf + beta*MRP = 5 + 1.8417*6 = 16.05%

Option A is correct.