Duramax Inc. manufactures car radios and reported $ 75 million in operating inco

Question

Duramax Inc. manufactures car radios and reported $ 75 million in operating income l ast year on revenues of $ I billion last year. The firm is all equity funded and you have computed a beta for the firm of 0.80. You have estimated the optimal debt ratio for the firm to be 40% debt, and you expect the firm to have $ 20 million in interest expenses at that debt ratio. Using the interest coverage ratio table at the bottom of this page, estimate the cost of capital for Duramax at the optimal debt ratio. The risk free rate is 4%. the tax rate is 40% and the equity market risk premium is 4.82%.

Explanation / Answer

Cost of equity. Ke = Rf+×Rp

Rf is risk free return

Rp is risk premium

= 4%+0.80×4.82%

= 7.86%

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