Mass Inc. is trying to estimate its optimal capital structure. Right now, Mass I
ID: 2780196 • Letter: M
Question
Mass Inc. is trying to estimate its optimal capital structure. Right now, Mass Inc. has a capital structure that consists of 50 percent debt and 50 percent equity, based on market values. (Its D/S ratio is 1.00) The risk-free rate is 6 percent and the market risk premium, Km-Krf, is 5 percent. Currently the company's cost of equity, which is based on the CAPM, is 12 percent and its tax rate is 40 percent. What would be Mass Inc.'s estimated cost of equity if it were to change its capital structure to 60 percent debt and 40 percent equity?
Explanation / Answer
If Debt is 50% and Equity is 50%:
Cost of Equity = 12%
risk-free rate = 6%
market risk premium = 5%
Cost of Equity = risk-free rate + levered beta * Market risk premium
12% = 6% + levered beta * 5%
6% = levered beta * 5%
levered beta = 1.2
Unlevered beta = levered beta / [1 + (1-tax)*(D/S)]
Unlevered beta = 1.2 / [1 + (1-0.40)*(1.00)]
Unlevered beta = 1.2 / 1.60
Unlevered beta = 0.75
If Debt is 60% and Equity is 40%:
Unlevered beta = levered beta / [1 + (1-tax)*(D/S)]
0.75 = levered beta / [1 + (1-0.40)*(0.60/0.40)]
0.75 = levered beta / 1.90
levered beta = 1.425
Cost of Equity = risk-free rate + levered beta * Market risk premium
Cost of Equity = 6% + 1.425 * 5%
Cost of Equity = 6% + 7.125%
Cost of Equity = 13.125%
So, estimated cost of equity is 13.125%