RRR on equity would have been 18.00%The risk-free rate is 3%. If the company swi
ID: 2793749 • Letter: R
Question
RRR on equity would have been 18.00%The risk-free rate is 3%. If the company switches to 60 debt the cost of debt is estimated at 9%. a. Calculate the opportunity cost of capital (required return on assets, RA) b. Calculate the current WACC c. Calculate the cost of equity after the switch to 60% debt. d. Calculate the WACC after the switch to 60% debt. The required rate of return on the assets of American Eagle Inc. is 17%. The required return on the market is 14% and the risk-free rate is 4%. The company's current capital structure is 40% debt and 60% equity, the beta of its debt is 0.05, and its tax rate is 40%. 3. a. Calculate the cost of debt b. Calculate the cost of equity under the no tax assumption. c. Calculate the beta of equity when taxes are applicable. d. Calculate the required return on equity using CAPM. e. Calculate the required return on equity using rA when taxes are applicable.Explanation / Answer
1
Cost of debt=4%+0.05*(14%-4%)=4.5%
2
Return on Assets=40%*4.5%+cost of equity*60%
=>cost of equity=(17%-40%*4.5%)/60%=25.33%
3
asset beta=(17%-4%)/10%=1.3
So, asset beta=0.4*(1-40%)*beta of debt+0.6*beta of equity
=>beta of equity=(1.3-0.4*0.6*0.05)/0.6=2.1467
4
required retun on equity=2.1467*10%+4%=25.467%
5
return on assets=return on debt*0.4*0.6+return on equity*0.6
=>return on equity=(17%-4.5%*0.4*0.6)/0.6=26.53%
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