ART's CEO is considering a change to the company's capital structure, which currently consists of 25% debt and 75% equity. The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio. The risk-free rate, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm's tax rate is 40%. Currently, the cost of equity, rs, is 11.5% as determined by the CAPM. What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem.)
| D/A = | |||||||||
| D/E=D/(A-D)=0.25/(1-0.25)=0.3333 | |||||||||
| As per CAPM | |||||||||
| expected return = risk-free rate + beta * (Market risk premium) | |||||||||
| 11.5 = 5 + Beta * (6) | |||||||||
| Beta = 1.08 | |||||||||
| Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity))) | |||||||||
| 1.08333333333333 = Unlevered Beta*(1+((1-0.4)*(0.333333333333333))) | |||||||||
| Unlevered Beta = 0.9 | |||||||||
| D/A =0.6 | |||||||||
| D/E=D/(A-D)=0.6/(1-0.6)=1.5 | |||||||||
| Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity))) | |||||||||
| levered beta = 0.9*(1+((1-0.4)*(1.5))) | |||||||||
| levered beta = 1.71 | |||||||||
| As per CAPM | |||||||||
| expected return = risk-free rate + beta * (Market risk premium) | |||||||||
| Expected return% = 5 + 1.71 * (6) | |||||||||
| Expected return% = 15.26 |
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