14. Greshak Corp. is attempting to estimate its optimal capital structure. Curre

Question

14. Greshak Corp. is attempting to estimate its optimal capital structure. Currently, the company has a capital structure that consists of 20% debt and 80% equity, based on market values. The risk-free rate is 6.0%, the firm's ROA is 9.5%, and the equity market risk premium is 5.0%. Currently the company's cost of equity, which is based on the CAPM, is 12% and its tax rate is 40%. What would be Greshak's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?

Select one:
A. 13.00%
B. 13.64%
C. 14.35%
D. 14.72%
E. 15.60%

Explanation / Answer

Cost of equity according to capm model

=Rf+Beta*(Rm-Rf)

Rf=risk free rate Rf-Rm= market risk premium and beta is security risk

12%=6%+(beta*5%)

leevred beta=1.2 d/e=20/80=,25 tax=40%

Levered beta=unlevered beta*(1+(d/e)*(1-tax))

1.2=unlevered beata*(1+.25*(1-..4))

unlevered beta=1.04

according to new capital structure D/e=50%/50%=1

Levered beata= unlevered beat*(1+D/e*(1-tax))

=1.04*(1+(1-,4))

=1.67

As per CAPM cost of equity

=6%+1.67*5%

=14.35%

Option C

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