A consultant has collected the following information regarding Young Publishing:

Question

A consultant has collected the following information regarding Young Publishing:

Total assets            $3,000 million                                Tax rate                                40%

Operating income (EBIT)              $800 million         Debt ratio                              0%

Interest expense                             $0 million        WACC                                   10%

Net income                                        $480 million          M/B ratio                                1.00×

Share price                                         $32.00                 EPS = DPS                            $3.20

The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). The consultant believes that if the company moves to a capital structure financed with 20 percent debt and 80 percent equity (based on market values) that the cost of equity will increase to 11 percent and that the pre-tax cost of debt will be 10 percent. If the company makes this change, what would be the levered cost of equity? (The answers are in millions.)

Explanation / Answer

The levered cost of equity is 11%, as when the capital structure changed to 20% debt and 80% equity, the cost of equity increased to 11%, ,

So the ans is option 3 - 11%

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