Heleveton Industries is 100% equity financed. Its current beta is 1.1. The expec

Question

Heleveton Industries is 100% equity financed. Its current beta is 1.1. The expected market risk premium is 8.5% and the risk-free rate is 4.2%. If Heleveton changes its capital structure to 25% debt, it estimates its beta will increase to 1.2. If the after-tax cost of debt will be 6%, should Heleveton make the capital structure change?       

   a. Yes, cost of capital decreases by 2.52%
     b. Yes, cost of capital decreases 1.67%.
     c. No, stock price would decrease due to increased risk
     d. No, cost of capital increases by 0.85%.

Explanation / Answer

Current cost of capita = 4.2%+1.1*(8.5%) = 13.55%

After changes its capital structure

cost of equity = 4.2%+1.2*(8.5%) = 14.40%

Cost of capital = 25%*6% + 75%*14.4% = 12.3%

Reduction in cost of capital = 13.55-12.3 = 1.67%

b. Yes, cost of capital decreases 1.67%.

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