Laramie Trucking's CEO is considering a change to the company's capital structure, which currently consists of 25% debt and 75% equity. The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio. The risk-free rate, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm's tax rate is 40%. Currently, the cost of equity, rs, is 11.5% as determined by the CAPM. What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem.)

Question

Quizplus · Accepted Answer

$\begin{array}{l}
\begin{array} { l } 
\text { Original } \mathrm{r}_{\mathrm{S}}\
\text {Current D/A}\
\text { rRF }\
\mathrm{RP}_{\mathrm{M}}\
\text {Tax rate}\
\text {Target D/A}\
\end{array}
\begin{array} { l } 
11.5\%\
25\%\
5\%\
6\%\
40\%\
60\%\
\end{array}
\end{array}$
 
 $\begin{array}{llr}
\text { Original b: } & r_{\mathrm{S}}=1_{\mathrm{RF}}+\mathrm{b}_{\mathrm{L}}\left(\mathrm{RP}_{\mathrm{M}}\right) ; \mathrm{b}=\left(\mathrm{r}_{\mathrm{S}}-\mathrm{r}_{\mathrm{RF}}\right) / \mathrm{RP} \mathrm{M}_{\mathrm{M}} & 1.083 \
\text { Original } \mathrm{D} / \mathrm{E}: & \mathrm{D} / \mathrm{A} /(1-\mathrm{D} / \mathrm{A})= & 0.3333 \
\text { Unlevered beta: } & \mathrm{b}_{\mathrm{U}}=\mathrm{b}_{\mathrm{L}} /(1+(\mathrm{D} / \mathrm{E})(1-\mathrm{T})) & 0.90 \
\text { Target } \mathrm{D} / \mathrm{E}= & & 1.50 \
\text { New beta: } & \mathrm{b}_{\mathrm{L}}=\mathrm{b}_{\mathrm{U}}(1+(\mathrm{D} / \mathrm{E})(1-\mathrm{T})) & 1.7153 \
\mathrm{r}_{\text {Sew }}=1_{\mathrm{RF}}+\mathrm{b}_{\mathrm{L} N e w}\left(\mathrm{RP}_{\mathrm{M}}\right)= & & 15.29 \%
\end{array}$

Laramie Trucking's CEO Is Considering a Change to the Company's