Kelly Tubes is considering a merger with Reilly Tires. Reilly's market-determined beta is 0.9, and the firm currently is financed with
20% debt, at an interest rate of 8%, and its tax rate is 25%. If Kelly acquires Reilly, it will increase the debt to 60%, at an interest rate of 9%, and the tax rate will increase to 35%. The risk-free rate is 6% and the market risk premium is 4%. What will Reilly's required rate of return on equity be after it is acquired?

Question

Quizplus · Accepted Answer

The required rate of return on equity can be calculated using the levered beta formula and the CAPM. First, calculate the new levered beta using the formula: βL = βU * [1 + (1 - Tax Rate) * (Debt/Equity)]. The unlevered beta (βU) is calculated from the original beta and capital structure. Then, use the new levered beta in the CAPM formula: Required Return = Risk-Free Rate + Levered Beta * Market Risk Premium.

Kelly Tubes Is Considering a Merger with Reilly Tires