Daniel Electronics is considering a change in its target capital structure, whic

Question

Daniel 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 firms
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.)

Explanation / Answer

The current beta is calculated using the below equation:

Rs = Rf + beta * RPM

11.5 = 5 + beta* 6

6 beta = 6.5

beta = 1.083

This is the beat with 35% debt

Now we find the Unlevered beta using hamafa equation: BU = BL/ [1+ (1-T)*D/E]

where BL =1.083 , t = tax rate = 0.4 and D/E = 35/65

Beta Unlevered =1.083/(1+0.6*35/65) = 0.8185

Now let us find the levered beta with 60% debt BL = BU*(1+(1-tax rate)*D/E) = 0.8185 *(1+0.6*60/40) = 1.555

Hence levered beta with 60% debt = 1.555

Hence Cost of equuity = Rf + beta * RPM = 5 + 1.555* 6 = 14.33%

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