Question

Question 35 3 pts Currently, Bloom Flowers Inc. has a capital structure consisting of 20% debt and 80% equity. Bloom's debt currently has an 3.2% yield to maturity. The risk- free rate (FRF) is 3.6%, and the market risk premium (rm-rRF) įs 7.3%. Using the CAPM, Bloom estimates that its cost of equity is currently 12.7%. The company has a 24% tax rate. Bloom's financial staff is considering changing its capital structure to 40% debt and 60% equity. If the company went ahead with the proposed change, the yield to maturity on the company's bonds would rise to 11%. The proposed change will have no effect on the company's tax rate. | What would be the company's new cost of equity if it adopted the proposed change in capital structure?

Answer 1

Current Capital Structure:

Cost of Equity = Risk-free Rate + Levered Beta * Market Risk Premium
12.70% = 3.60% + Levered Beta * 7.30%
9.10% = Levered Beta * 7.30%
Levered Beta = 1.25

Unlevered Beta = Levered Beta / [1 + (1 - tax) * (D/E)]
Unlevered Beta = 1.25 / [1 + (1 - 0.24) * (0.20/0.80)]
Unlevered Beta = 1.25 / 1.19
Unlevered Beta = 1.05

Proposed Capital Structure:

Levered Beta = Unlevered Beta * [1 + (1 - tax) * (D/E)]
Levered Beta = 1.05 * [1 + (1 - 0.24) * (0.40/0.60)]
Levered Beta = 1.05 * 1.5067
Levered Beta = 1.58

Cost of Equity = Risk-free Rate + Levered Beta * Market Risk Premium
Cost of Equity = 3.60% + 1.58 * 7.30%
Cost of Equity = 15.13%

So, new cost of equity will be 15.13%