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Homework answers / question archive / Your company currently has 60% equity and 40% debt capital structure
Your company currently has 60% equity and 40% debt capital structure. At the current state, it is estimated that your company's equity beta is 1.2 and debt beta is 0.8. a. If you would like to restructure your capital to 50% debt and 50% equity, what would be the equity beta of your firm?
b. If the risk-free rate is 3% and the market return is 15%, what would be your equity cost of capital under the new capital structure?
First we calculate Unlevered Beta:
Unlevered Beta = Levered Beta/(1+(1-Tax)*(Debt/Equity))
= 1.2/(1+(1-0)*(40%/60%))
= 1.2/1.6667
Unlevered Beta = 0.72
Now Debt is 50% and Equity is 50%. So,
Levered Beta = Unlevered Beta*(1+(1-Tax)*(Debt/Equity))
= 0.72/(1+(1-0)*(50%/50%))
= 0.72/2
Levered Beta = 1.44 (Answer)
Computation of Cost of Capital under New Capital Structure:
Cost of Capital = Risk-free Rate+Beta*(Market Return - Risk-free Rate)
= 3%+1.44*(15%-3%)
= 3%+1.44*12%
= 3%+17.28%
Cost of Capital = 20.28% (Answer)
