Question

Barry Boats currently has $200 of common stock outstanding and a $300 loan. The beta on the stock is currently 0.75. The firm is considering taking out an additional $100 loan and using the cash to buy back some of its own stock. If the risk free rate is 3% and the market return is 14%, how much will cost of equity increase? The tax rate is 25%.

Answer 1

Old Cost of equity using CAPM = Risk free rate + Beta * Market risk premium= 3% + 0.75*(14%-3%) = 11.25%

Old Levered Beta = 0.75

Original D/E ratio = 300/200 = 1.5

Unlevered Beta = Levered Beta /(1+ D/E *(1-t)) = 0.75/(1+ 1.5*(1-25%)) = 0.3529= 0.3529

New Debt = 300 + 100 = $ 400

New Equity = 200 -100 = $ 100

New D/E ratio = 400/100 =4 times

Levered Beta = Unlevered Beta*(1+ (D/E *(1-t)) = 0.3529*(1+(4*(1-25%)) = 1.41

New Cost of Equity = 3% + 1.41* 11% = 18.52%

Increase in Cost of Equity = 18.52% - 11.25% = 7.27%