Question 25 -The all equity firm’s current cost of equity is 9.12 %. Market risk

Question

Question 25 -The all equity firm’s current cost of equity is 9.12 %. Market risk premium is 4% and risk free rate is 6%. The firm’s tax rate is 40%. The firm is considering refinancing by selling bonds and repurchasing stock. The new debt will be issued in the amount of $40 million, paying interest at a rate of 10%, and for every dollar of equity issued there will be 3.1 dollars of debt . What will the firm’s cost of equity be after refinancing?

Hint - book answer is 18.79%. What formulas to use?

Explanation / Answer

Answer:

Given:
Cost of equity (RE) = 9.12%
Return on debt (RD) = 10%
Debt/Equity = 3.1
Tax Rate = 0.40

In an all equity firm, Return on Asset is cost of equity
so, Return on asset (RA) = 9.12%

Calculation of cost of equity after refinancing:

RE = RA + [(Debt/Equity) X (RA - (RD * (1 - tax)))]
= 9.12 + [3.1 X (9.12 - (10 X (1 - 0.40)))]
= 9.12 + (3.1 X (9.12 - 6))
= 9.12 + (3.1 X 3.12)
= 9.12 + 9.672
= 18.79%

Therefore, the cost of equity after refinancing is 18.79%.

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