Question

Laramie Trucking'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 25%. 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?A) 10.95%.
B) 11.91%.C) 12.94%.D) 14.07%.E) 15.29%.

Answer 1

Answer:

Re = 15.29%

Explanation:

beta at current debt level:

11.5% = 5% + (beta x 6%)

6.5% = 6%beta

beta = 6.5% / 6 = 1.083

unlevered beta = 1.083 / {1 + [(1 - tax rate) x debt / equity]} = 1.083 / {1 + [(1 - 40%) x 25 / 75]} = 1.083 / 1.2 = 0.9025

cost of levered beta at 60% debt:

0.9025 = beta / {1 + [(1 - 40%) x 60 / 40]}

0.9025 x 1.9 = beta

beta = 1.7148

Re = 5% + (1.7148 x 6%) = 15.29%