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A company is trying to estimate its optimal capital structure
A company is trying to estimate its optimal capital structure. Right now, the company has a capital structure that consists of 20% debt and 80% equity, based on market values (that means the debt to equity D/S ratio is 0.25). The risk-free rate (rRF) is 5% and the market risk premium (rM - rRF) is 6%. Currently the company's cost of equity, which is based on the CAPM, is 14% and its tax rate is 20%. Find the firm's current leveraged beta using the CAPM?
Find the firm's unleveraged beta using the Hamada Equation,
Based on question above what would be the company's new leveraged beta if it were to change its capital structure to 50% debt and 50% equity (D/S=1.0) using the Hamada Equation? and what would be the company's new cost of equity if it were to change its capital structure to 50% debt and 50% equity (D/S =1.0) using the CAPM?
Expert Solution
Computation of the current leveraged beta using the CAPM:-
Cost of equity = Risk free rate + (Beta * Market risk premium)
14% = 5% + (Beta * 6%)
Beta * 6% = 14% - 5%
Beta = 9% / 6%
= 1.5
Computation of the unleveraged beta using the Hamada Equation:-
Unlevered beta = Levered beta / (1+(1-Tax rate)*(D/E ratio))
= 1.5 / (1+(1-20%)*0.25)
= 1.5 / 1.2
= 1.25
Computation of the new levered beta using Hamada equation:-
Levered beta = Unlevered beta * (1+(1-Tax rate)*(D/E ratio))
= 1.25*(1+(1-20%)*(50%/50%))
= 1.25*1.8
= 2.25
Computation of the new cost of equity using CAPM:-
New cost of equity = Risk free rate + (Beta * Market risk premium)
= 5% + (2.25 * 6%)
= 5% + 13.50%
= 18.50%
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