Question

Circle Inc. currently uses no debt, but its new CFO is considering changing the capital structure to 77.5% debt (wa) by issuing bonds and using the proceeds to repurchase and retire some common shares so the percentage of common equity in the capital structure (wc = 1 - wa). Given the data shown below, the cost of equity under the new capital structure minus the cost of equity under the old capital structure is __ _%. If your answer is 1.23% then input 1.23 in the answer box. Risk-free rate, If 5.00% Tax rate,t Market risk premium 3.50% ent wit Current beta, by arget wd 77.59

Answer 1

Required : New Cost of Equity under new capital Structure - Cost of Equity under Old Capital Structure.

Calculation of Cost of Equity as Per CAPM Model

Kc = Rf + Beta x( Rm-Rf)

Where Rf = Risk Free Return = 5%

( Rm-Rf)= Market Risk Premium = 3.5%

Kc under Old Capital Structure = Rf + Beta x(Rm-Rf)

=5%+1.65 x (3.5)

=10.775%

Kc Under New Capital Structure, before that we have to calculate Beta of company under new Capital Structure

Levered Beta = Company Beta x (1 + (1- tax rate)(D/E)

Were D/E = Debt equity Ratio = 77.5/22.5 =3.44

Company Beta = 1.65

tax rate =25%

Substituting the values

we get Levered Beta = 1.65 x (1 +((1-.25) x 3.44)

Levered Beta = 5.907

Cost of Equity Using CAPM Model = Rf + (Levered Beta x Market Premium)

= 5+( 5.907 x 3.5)

= 25.6745

Cost of Equity under new capital Structure - Cost of Equity under Old Capital Structure.

= 25.6745 %-10.775%

=14.8995%, which can be rounded to 14.90%

Answer Cost of Equity under new capital Structure - Cost of Equity under Old Capital Structure = 14.90%