6. Stephens Electronics is considering a change in its target capital structure,

Question

6. Stephens Electronics is considering a change in its target capital structure, which currently consists of 35% debt and 65% equity. The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio. The risk-free rate, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm’s tax rate is 40%. Currently, the cost of equity, rs, is 11.5% as determined by the CAPM. What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem, Hamada Equation would be good to use.)

Explanation / Answer

Computation of Beta by using CAPM model

Ke = Rf + beta(Rm-Rf)

Where Rf = Risk free rate

Rm = Market rate

Ke = cost of equity

Then Beta =(11.5-6)/6

Beta =0.92

Unlevereged Bata = beta of business/(1+(1-t)*debt equity ratio)

=0.92(1+(1-04%)*35%/65%)

=1.4

Now cost of capital by using unlevereged beta = 5+1.4*6

=13.4%

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