Question

Company 3 does not currently have any debt. Its tax rate is .4 and its unlevered beta is estimated by examining comparable companies to be 2.0. The 10-year Treasury bond rate is 6.25% and the historical risk premium over the risk free rate is 5.5%. Next year, company 3 expects to borrow up to 75% of its equity value to fund future growth. Required (a) Calculate the company’s current cost of equity. (5 marks) (b) Estimate the firm’s cost of equity after it increases its leverage to 75% of equity?

Answer 1

Company 3’s current cost of equity can be determined using the Capital Asset Pricing Model (CAPM) formula, resulting in 17.25%. To estimate the new cost of equity after leveraging, the levered beta is needed, which requires specific debt and interest rate information that is not provided.

Step-by-step explanation:

To calculate Company 3's current cost of equity, we use the Capital Asset Pricing Model (CAPM), which is given by the formula:

Cost of Equity = Risk-Free Rate + (Beta * Market Risk Premium)

Giving us:

Cost of Equity = 6.25% + (2.0 * 5.5%)

Cost of Equity = 6.25% + 11% = 17.25%

For part (b), estimating the firm’s cost of equity after it increases its leverage to 75% of its equity can be done by adjusting the unlevered beta to a levered beta using the formula:

Levered Beta = Unlevered Beta * (1 + (1 - Tax Rate) * (Debt/Equity))

However, the provided information does not match the query, resulting in an absence of specific numerical details required for this calculation, such as the actual interest rate on the new debt. Given the data provided, we cannot compute the precise levered beta, and as a consequence, the cost of equity after leverage cannot be precisely determined.