Question

Federal Inc. currently finances with 25% debt (i.e., wd = 25%), but its new CFO is...

Federal Inc. currently finances with 25% debt (i.e., wd = 25%), but its new CFO is considering changing the capital structure so wd = 50% by issuing additional bonds and using the proceeds to repurchase and retire common shares so the percentage of common equity in the capital structure (wc) = 1 – wd. Given the data shown below, by how much would this recapitalization change the firm's cost of equity? (Hint: You must unlever the current beta and then use the unlevered beta to solve the problem.)

Risk-free rate, rRF 5.00% / Tax rate, T 40%

Market risk premium, RPM 6.00% / Current wd 25%

Current beta, bL1 1.20 / Target wd 50%

Options: 2.20%, 2.30%, 2.40%, 2.50%, 2.60%

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