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

Question

5. Stephens 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 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, Hamada Equation would be good to use.) a. 14.99% b. 14.33% c. 13.94% d. 13.57% e. 12.73%

Explanation / Answer

Solution.

Risk-free rate, rRF, is 5.0%

Stock rate of return = 11.5%.

Market risk premium, RPM, is 6.0%.

Current beta =

Stock rate of return = 11.5%. - Risk-free rate, rRF, is 5.0%. = 6%

Market risk premium, RPM, is 6.0%. - Risk-free rate, rRF, is 5.0% = 1%

Beta = 6% / 1% = 6%

Unlevered Beta = Levered Beta / (1 + ((1 – Tax Rate) x (Debt/Equity)))

=6 / (1 + ((1 – 40%) x (40/60)))

= 3.75 x 0.67 = 2.51

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