Q CO. has a capital structure that consists of 100% equity. The risk free rate is...

Q CO. has a capital structure that consists of 100% equity. The risk free rate is 7% and the market risk premium, (Rm – Rr), is 5%. Currently the company’s cost of equity (rs), which is based on CAPM, is 12% and its tax rate is 30%. What would be Q’s estimated cost of equity if it were to change its capital structure to 30% debt and 70% equity? Compute the business risk premium and financial risk premium under the new capital structure and confirm that Rs = Rr + BRPM + FRPM

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Expert Solution

Using CAPM model,

0.12 = 0.07 + Beta(0.05)

Beta = 1

With Capital Structure of Debt 30% and Equity 70%

Levered Beta = 1(1 + (1 - 0.30)(0.30/0.70))

Levered Beta = 1.30

Cost of Equity = 0.07 + 1.30(0.05)

Cost of Equity = 13.50%

jeff jeffy answered 2 years ago

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