Question

The firm is trying to estimate its optimal capital structure. Right now, the firm has a capital structure that consists of 50% debt and 50% equity. The risk-free rate is 2.5% and the market risk premium is 12%. Currently the company's cost of equity, which is based on the SML. is 18.5% and its tax rate is 21%. What would be the firms estimated cost of equity if it were to change its capital structure to 40% debt and 60% equity?

A. 11.44%

B. 18.5%

C. 16.14%

D. 21.26%

E. 19.18%

Answer 1

Debt to Equity =50%/50% =1
Cost of Equity levered =18.5%
Cost of equity levered = Cost of Equity unleverd + Debt/Equity*( Cost of Equity unlevered - Cost of Debt)*(1-Tax Rate)
18.50% =Cost of Equity Unlevered+1*(Cost of Equity Unlevered-2.5%)*(1-21%)
18.50% =Cost of Equity Unlevered +0.79*Cost of Equity Unlevered -2.5%*0.79
Cost of Equity Unlevered =(18.50%+2.5%*0.79)/1.79 =11.4385%

Cost of Equity Levered =Cost of Equity Unlevered+1*(Cost of Equity Unlevered-2.5%)*(1-21%)
=11.4385%+40%/60%*(11.4385%-2.5%)*0.79 =16.14%

(Option c is correct option)