4. Leverage effects on beta Maitland Inc. currently has a capital structure cons

Question

4. Leverage effects on beta Maitland Inc. currently has a capital structure consisting of 20% debt and 80% equity. However, Maitland?s CFO has suggested that the firm increase its debt ratio to 50%. The current risk-free rate is 6% and the market risk premium is 5%, while Maitland?s beta is 1.05. lithe firm?s tax rate is 40%, what would the beta of an all-equity firm be if its operations were exactly the same? 0.9130 0.9583 0.8750 1.0870 1.0000 If Maitland raised its debt ratio to 50%, how much would its cost of equity change? 2.50% 2.45% 2.74% 2.05% 2.25%

Explanation / Answer

1. Unlevered Beta = Levered Beta / [1 + (D/E) x (1-t)] = 1.05 / [1 + (0.2/0.8) x (1 - 0.4)] = 0.9130. Thus, Option A.

2. Levered Beta = 0.9130 x [1 + (0.5/0.5) x (1-0.40)] = 1.46
New Cost of Equity = 6 + (5 x 1.46) = 13.3%
Old Cost of Equity = 6 + (5 x 1.05) = 11.25%
Change in cost of equity = 13.30 - 11.25 = 2.05%. Thus, Option D.

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