Question

You have the following data on The Home Depot, Inc.

Market value of long-term debt: $20,888 million

Market value of common stock: $171,138 million

Beta: 1.04

Yield to maturity on debt with 10 years to maturity: 2.167%

Expected return on equity: 8.762%

Marginal tax rate: 35%

Assume that if Home Depot issues new bonds, the bonds will have 10 years to maturity.

Suppose that managers at Home Depot decide to increase the proportion of debt to 20% of the value of the company. The managers estimate that yield on the company’s 10 year bonds will rise to 2.333% if the company changes its capital structure in this manner.

What would be the expected rate of return on equity under the new capital structure?

Do not round at intermediate steps in your calculation. Express your answer in percent. Round to two decimal places. Do not type the % symbol.

Answer 1

rSL = rSU + (rSU-rD)/(1-t)*(D/S), where

rSL = cost of levered equity, rSU = cost of unlevered equity, rD = before tax cost of debt, D = value of debt and S = value of equity.

Return on levered equity can be computed using:

wherein

Given values:

%

D = $20,881

E = $171,138

%

Now, subsituting the values in the above equation:

So, unlevered cost of equity is 8.93392%

Given information for new capital structure:

%

%

%

D = 20%

E = 1 - 20% = 80%

%

Now, subsituting the values in the above equation:

Final answer: expected rate of return on equity in new capital structure would be 10.01%.