Question

40. A company is estimating its optimal capital structure. Now the company has a capital structure...

40. A company is estimating its optimal capital structure. Now the company has a capital structure that consists of 50% debt and 50% equity, based on market values (debt to equity D/S ratio is 1.0). The risk-free rate (rRF) is 3.5% and the market risk premium (rM – rRF) is 5%. Currently the company’s cost of equity, which is based on the CAPM, is 13.5% and its tax rate is 30%. Find the firm’s current leveraged beta using the CAPM

2.0

1.5

2.6

1.9

41. Based on the information from Question 40, find the firm’s unleveraged beta using the Hamada Equation

1.95

1.0

1.18

1.29

42. Based on the information from Question 40 and 41, what would be the company’s new leveraged beta if it were to change its capital structure to 60% debt and 40% equity (D/S=1.5) using the Hamada Equation?

1.65

1.95

2.16

2.41

43. Based on the information from Questions 40 ~ 42, what would be the company’s new cost of equity if it were to change its capital structure to 60% debt and 40% equity (D/S =1.5) using the CAPM?

13.8%

15.6%

16.8%

18.5%

Homework Answers

Answer #1

Solution:

40.Calculation of firm’s current leveraged beta using the CAPM

Cost of equity=Risk free rate+Beta*Market risk premium

13.5%=3.5%+Beta*5%

Beta=10.00%/5%

=2

41.Calculation of firm’s unleveraged beta using the Hamada Equation

unleveraged beta=Leveraged beta/1+(1-tax rate)*debt/equity

=2/1+(1-0.30)*1

=1.176 or 1.18

42.Calculation of company’s new leveraged beta sing the Hamada Equation

New leveraged beta=UnLevarged beta[1+(1-tax rate)*Debt/equity]

=1.18[1+(1-0.30)*1.5]

=2.419 or 2.41

43.Calculation of company’s new cost of equity

New Cost of equity=Risk free rate+Beta*Market risk premium

=3.5%+2.41*5%

=15.55 or 15.60%

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