Question

You evaluate 3 companies under the impact of an economic crisis on financing costs.

The corporate tax rate for all companies is 21 percent. Assume that the market risk premium has increased, and the riskless rate has not changed due to the crisis. Choose the correct option regarding the cost of capital for these companies during the crisis?

- HULA has an unlevered beta of 0.26, a debt-to-equity ratio of 3.77.

- Tesla has an unlevered beta of 0.15, a debt-to-equity ratio of 4.87.

- Apple has an unlevered beta of 0.43, a debt-to-equity ratio of 2.17.

I.   HULA's cost of equity has increased more compared to Tesla.

II. Apple’s equity investors require a higher return compared to HULA and Tesla.

III. To experience the same increase in cost of equity as Apple, Tesla should decrease its debt-to-equity ratio.

	A.	I and III
	B.	I and II
	C.	Only II
	D.	I, II, and III
	E.	II and III

Answer 1

As we can see in the above formula that While calculating Required return on equity or cost or equity ,we need to multiply market risk premium to levered beta ,therefore when levered beta is higher than increase in cost of equity or required return will be higher .

Therefore due to increase in market risk premium ,Apple will experience highest increase because it's levered beta is highest then HULA and then Tesla

Therefore statement I and II are correct.

Now To experience the same increase in cost of equity as in Apple ,Tesla need to increase its levered beta and we can see in the formula of levered beta that it can be done only by increasing debt equity ratio

Hence statement III is false

Hence correct option is (B)