Question

Company b'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, i.e., what is rl - ru?

a. 2.12%
b. 0.71%
c. 1.77%
d. 2.83%
e. 11.55%

Answer 1

The capital structure shift in here will not change the firm's cost of equity. The answer is 0% (option b).

Step-by-step explanation:

The cost of equity refers to the return required by shareholders in a company. It is calculated using the Capital Asset Pricing Model (CAPM), which takes into account the risk-free rate, the company's beta, and the market risk premium. In this case, the risk-free rate is 5.0% and the market risk premium is 6.0%.

Currently, the company's cost of equity (rl) can be calculated as follows:

rl = risk-free rate + beta * market risk premium

rl = 5.0% + 1.10 * 6.0% = 11.60%

If the company moves to a capital structure with 30% debt and 70% equity, the cost of equity will change. The cost of equity in this new capital structure (ru) can be calculated as follows:

ru = risk-free rate + beta * market risk premium

ru = 5.0% + 1.10 * 6.0% = 11.60%

Therefore, the capital structure shift will not change the firm's cost of equity. The difference between rl and ru is 0, which means the answer is 0% (option b).