Question

The required return on equity for an all-equity firm is 10.0 percent. They currently have a beta of one and the risk-free rate is 5 percent and the market risk premium is 5 percent. They are considering a change in capital structure to a debt-to-equity ratio of ½ the tax rate is 40 percent, the pre-tax cost of debt is 8 percent. Find the beta if this firm changes capital structure.

Answer 1

1.3

Step-by-step explanation:

Data provided in the question:

The required return on equity for an all-equity firm = 10.0 percent

Risk-free rate = 5 percent

Market risk premium = 5 percent

Debt-to-equity ratio = ½ = 0.5

Tax rate = 40 percent

Pre-tax cost of debt = 8 percent

All equity beta = 1

Now,

Levered beta with the new capital structure

= All equity beta × [ 1 + Debt-to-equity ratio × (1- tax rate) ]

= 1 × [ 1 + 0.5 × (1 - 40%) ]

= 1.3