Capital Structure and Leverage - Solutions6

# Capital Structure and Leverage - Solutions6 - Percent...

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Old Exam Questions - Capital Structure and Leverage - Solutions Page 26 of 59 Pages Percent Financed Percent Financed Debt/Equity Bond Before-Tax With Debt With Equity Ratio Rating Cost of Debt 0.10 0.90 0.10/0.90 = 0.11 AA 7.0% 0.20 0.80 0.20/0.80 = 0.25 A 7.2% 0.30 0.70 0.30/0.70 = 0.43 A 8.0% 0.40 0.60 0.40/0.60 = 0.67 BB 8.8% 0.50 0.50 0.50/0.50 = 1.00 B 9.6% Now assume that the company’s tax rate is 40 percent, that the company uses the CAPM to estimate its cost of common equity, K s , that the risk-free rate is 5 percent and the market risk premium is 6 percent. Finally assume that if it has no debt its WACC would be equal to its cost of equity which would be equal to 11 percent (you should now be able to determine its “unlevered beta,” b U ). Given this information, determine the firm’s cost of capital if it finances with 40 percent debt and 60 percent equity. A. 9.26% B. 9.86% C. 9.56% * D. 10.16% E. 8.96% K S = 11% = .05 + (.06)(b U ) Therefore, b U = 1.0 Now, use the Hamada equation to lever the beta with the new debt/equity ratio: b L = [1.0][1 + (.67)(1-.40)] = 1.402 New K S = .05 + (.06)(1.402) = 13.412% New WACC = (.088)(1-.40)(.4) + (.13412)(.6) New WACC = 0.02112 + 0.080472 = 0.101592 = 10.16% 27. Assume that a firm’s current capital structure consists of 60 percent debt and 40 percent stock, that the tax rate is 40 percent, that the stock has a levered beta of 1.90, that the risk-free rate is 4.0%, that the return on the market is 10.0%, and that the firm’s WACC is currently 8.32%. Assume now that the firm wishes to change its capital structure to 40 percent debt and 60 percent stock, and that they believe that this decrease in leverage will decrease the before-tax cost of the debt to 5.0%. Using the Hamada equations to unlever and

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Old Exam Questions - Capital Structure and Leverage - Solutions Page 27 of 59 Pages relever beta (take out to at least 4 decimal places), determine what the firm’s new cost of stock will be if they make this change. A.
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## This note was uploaded on 07/13/2011 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.

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Capital Structure and Leverage - Solutions6 - Percent...

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