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Morales Publishing's tax rate is 40%, its beta is 0.8, and it uses no debt. However,...

Morales Publishing's tax rate is 40%, its beta is 0.8, and it uses no debt. However, the CFO is considering moving to a capital structure funded by debt, which produces a beta of 1.8. If the risk-free rate is 1% and the market risk premium is 8%, by how much would the capital structure shift change the firm's cost of equity (in percent)?

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Answer #1

rate positively ..

Existing scenario
Beta= 0.8
Risk free rate = 1%
Market risk premium = 8%
Cost of equity = Risk free rate + Market risk premium*beta
1%+8%*0.8
7.40%
Revised scenario
Beta= 1.8
Risk free rate = 1%
Market risk premium = 8%
Cost of equity = Risk free rate + Market risk premium*beta
1%+8%*1.8
15.40%
Change in cost of equity = 15.4%-7.4% 8.00%
Ans = Increase in cost of equity by 8%.
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