Question

Equinoa Enterprises currently finances with 20% debt, but its new CFO is considering changing it to 36% debt by issuing additional bonds and using the proceeds to repurchase and retire common shares of stock. Given the following data, by how much would this recapitalization change the firm's cost of equity? Do not round your intermediate calculations. RRF = 5%, Market risk premium, RPm = 6%, Tax rate = 40%, Current beta = 1.65, Current debt ratio = 20%, Target debt ratio = 36%. A) B) C) D) E) 1.61% 1.66% 1.24% 1.68% 1.69%

Answer 1

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Answer:

Current beta = 1.65

20% debt and 80% equity

Unlevered beta = levered beta/(1+(1-t) D/e)) = 1.65/(1+ (1-0.4)*1/4))= 1.43478

Levered beta =1.43478 (1 + (1-t)*d/e)= 1.919

New re = rf + beta(rm - rf)

= 5% + 1.919(6%) = 16.514

Old re = rf + beta(rm - rf)

= 14.9%

=> Difference = 16.514 - 14.9 = 1.61%