Question

Arbitra Inc.'s current capital structure is 30% debt and 70% equity. The expected return on its debt is 5%, its equity Beta is 1.1. The riskfree rate is 2%, and the expected return on the market is 10%. Consider first (in questions (i) and (ii)) the case of perfect capital markets. a) Calculate Arbitra Inc.'s asset Beta and its cost of capital (that is, Arbitra Inc.'s expected return on assets). b) Arbitra Inc. now decides to change its capital structure to 50% debt and 50% equity; as it does so, its total assets are not affected, but its debt becomes riskier and the debt Beta increases to 0.6. Calculate the firm's expected return on equity under this new capital structure.

Answer 1

structure = ginen: current capital 30% debt & 70% equity IK Expected retum on debt = sy. (Be) equity Beta 24 Experted fetum on market - 10% (Rm) (R4) Riskfree safe (i) Asset's pela & cost of capital. Bla Be Assef Beta or unlevered Beta. (Paor Bu) It D olw - fa Be It % 0.77 11 Ans It 0.3) 10.1 wdkd t We ke cost of capital (APM ( capital will use asset pricing model) we for ke + (Rm - Rp) ße Rf ke 2 + 110 - 20 X1.1 = 10.8% cs Searned with CamScanner

wdkd t we ke 0.7 x 10.8 - 0.3 x 5 t ī - 9.06% Ans (ii) new capital structure soy debt & 50% equity debt Beta increases to 0.6. Total assefs are not affected. =) asset peta unaffected. Ba ße we + Bd wd 0.77 Be xe Xo.5 + 0.68 0.5 0.77 0.680.5 Be 0.5 0.94 CAPM, Return on equity (ke) using + (Rm - Pf) Be ke f 2 + (10-2)x0.94 9.52% Ans. CS canner with CamScanner