Morales Publishing's tax rate is 25%, its beta is 1.10, and it uses no debt.However, the CFO is considering moving to a capital structure with 30% debt and 70% equity.If the risk-free rate is 5.0% and the market risk premium is 6.0%, by how much would the capital structure shift change the firm's cost of equity?

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Quizplus · Accepted Answer

The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM), which is given by the formula: Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium. Initially, the cost of equity is 5.0% + 1.10 * 6.0% = 11.6%. With the new capital structure, the firm's beta will increase due to the financial leverage. The new beta (βL) can be calculated using the formula: βL = βU[1 + (1 - Tax Rate)(Debt/Equity)], where βU is the unlevered beta (1.10), Tax Rate is 25%, Debt/Equity for the new structure is 30/70 or 0.4286. So, βL = 1.10[1 + (1 - 0.25)(0.4286)] = 1.10 * 1.3214 = 1.45354. The new cost of equity becomes 5.0% + 1.45354 * 6.0% = 13.72%. The change in the cost of equity is 13.72% - 11.6% = 2.12%.

Morales Publishing's Tax Rate Is 25%, Its Beta Is 1