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

Question

5. 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.)

a. 14.99% b. 14.33% c. 13.94% d. 13.57% e. 12.73%

Explanation / Answer

Assume current levered beta =bL Rs=Rf+RPM*bL 11.5%=5%+6%*bL so bL =1.08 Now we need to unlever beta Assume unlevered beta= bUL Beta of debt =bD=0 bUL=bD*D(1-t)/[D(1-t)+E] +bL*E/[D(1-t)+E] bUL= 1.08*0.65/(0.35*0.6+0.65)= so unlevered beta =0.816 Noe regear beta at D;E =60:40 Assume the regeared beta -bL1 BL1=BUL+(bUL-bD)*D(1-t)/E =0.816+0.816*0.60*0.6/(0.40)=                1.5504 So relevered beta =1.5504 Now cost of Equity at this captal structure= Rs=Rf+RPM*bUL1 =5%+6%*1.5504 =14.3% approx So cost of equity =14.3% Answer b is correct,

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