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

Question

Stephens Electronics is considering a change in its target capital structure, which currently consists of 25% debt and 75% 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.)

Explanation / Answer

As given in the question, rRf=5% RPM=6% Since we know that,rs=rRf+RPM*ße 11.5=5+6*ße ße=1.08 ße = > leverage ratio is 25/75 = 1/3=0.33 We know that, ß = (ße*E)/(D(1-t)+E) + ßd*D(1-t)/(D*(1-t) + E) As given in question ßd=0, since debt is risk free Therefore, ß = (ße*E)/(D(1-t)+E) ß = 1.08/(D/E*(1-t) + E) = 1.08/(1/3*(1-.4) + 1) = 1.08/1.2 = 0.9 now,debt = 60%,equity = 40% => D/E = 60/40=1.5 hence ß = (ße*E)/(D(1-t)+E)..now use new D/E ratio 0.9 = ße/(D/E*(1-t) + E) 0.9 = ße/(1.5*(1-.4)+1) on solving ße=1.71 hence when debt is 60% ße increases from 1.08 to 1.71

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