Morales Publishing's tax rate is 40%,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?
A) 1.53%
B) 1.70%
C) 1.87%
D) 2.05%
E) 2.26%

Question

Quizplus · Accepted Answer

Using the CAPM formula, we can calculate the cost of equity:

Cost of Equity = Risk-free rate + Beta * Market Risk Premium

Before the capital structure change:
Cost of Equity = 5.0% + 1.10 * 6.0% = 11.6%

After the capital structure change:
Debt-to-equity ratio = 30%/70% = 0.43
Using the formula for levered beta, we can calculate the new beta:
Beta Levered = Beta Unlevered [1 + (1 - Tax Rate) * Debt-to-Equity Ratio]
Beta Levered = 1.10 [1 + (1 - 0.40) * 0.43] = 1.27

Using the new beta in the CAPM formula, we can calculate the new cost of equity:
Cost of Equity = 5.0% + 1.27 * 6.0% = 13.4%

The difference between the new and old cost of equity is 13.4% - 11.6% = 1.7%, so the correct answer is B.

Morales Publishing's Tax Rate Is 40%,its Beta Is 1