Laramie Trucking\'s CEO is considering a change to the company\'s capital struct
ID: 2620834 • Letter: L
Question
Laramie Trucking's CEO is considering a change to the company's capital structure, which currently consists of 25% debt and 75% equity. The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio. The risk-free rate IRE S?0% the market ns prem um. RPM. S o 0% and the m a te s 4 %, Current the co stor equity, r is 1 1.5% as determined by the CAP What would be the estimated cost of e uit if the firm used 6 % debt? t. ou mus ir tind the current eta and then the unlevered beta to solve the problem.) ? 10.95% ? 11.91% 15.29% ? 14.07% ? 12.94%Explanation / Answer
Step 1: Calculation of current Beta
We have
Cost of Equity Ke = Rf + b ( Rm – Rf )
Where,
Rf – Risk free return
b – Beta
Rm – Expected return on market portfolio
Cost of Equity Ke = Rf + b ( Rm – Rf )
11.50 = 5 + b * 6
b* 6 = 6.50
b = 6.5 / 6
Beta = 1.0833
Step 2: Calculation of unlevered Beta (Aseet beta)
Asset Beta = Equity Beta / [(1+(1-tax rate)*(debt/equity)]
= 1.0833 / [(1+ .6*.25/.75)]
= 1.08 33/ (1+.2)
Asset Beta = .9028
Step 3: Calculation of levered beta at 60% debt
levered beta = unlevered beta * (1+ (1-tax rate) (Debt/Equity))
= .9028* ( 1+ .6*.6/.4))
= .9028* (1+.9)
=.9028 * 1.9
?levered beta =1.7153
Step 3: Calculation of cost of equity
Cost of Equity Ke = Rf + b ( Rm – Rf )
= 5 + 1.7153 * 6
= 15.29%
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