Question

Prokter and Gramble (PG) has historically maintained a debt-to-equity ratio (D/E) of approximately 0.4. Its return on equity is 7.5% and it can borrow at 4.3%. PG’s tax rate is 40%.

PG believes it can increase debt without any serious risk of distress or other costs. With a higher debt-to-equity ratio of 0.6, it believes its borrowing costs will rise only slightly to 4.6%.

1. Determine PG’s current asset return r_A (before increasing its debt-to-equity ratio)
2. Determine PG’s cost of capital after PG raises its debt-to-equity ratio to 0.6.

Answer 1

a) Asset return currently = [ 7.50% * (1 / 1.4) ] + [ 4.30% * (0.4/1.4) ]

                                   = 5.36 % + 1.23%

                                   = 6.59% Answer

2) Cost of capital after DE ration increase = [ 7.50% * (1 / 1.60) ] + [ 4.60% * (0.60/1.60) ]

                                                            = 4.6875% + 1.725%

                                                            = 6.4125% Answer