Question

Globex Corp. currently has a capital structure consisting of 30% debt and 70% equity. However, Globex Corp.’s CFO has suggested that the firm increase its debt ratio to 50%. The current risk-free rate is 3.5%, the market risk premium is 7%, and Globex Corp.’s beta is 1.25.

If the firm’s tax rate is 45%, what will be the beta of an all-equity firm if its operations were exactly the same? (.96,1.11,.86,1.01)   

Now consider the case of another company:

U.S. Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 10%, and its tax rate is 45%. It currently has a levered beta of 1.25. The risk-free rate is 3.5%, and the risk premium on the market is 7%.U.S. Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity. Increasing the firm’s level of debt will cause its before-tax cost of debt to increase to 12%.

First, solve for U.S. Robotics Inc.’s unlevered beta. (1.11,1.01,.91,1.21)

Relever U.S. Robotics Inc.’s beta using the firm’s new capital structure. (1.66,2.02,1.75,1.84)

Use U.S. Robotics Inc.’s levered beta under the new capital structure, to solve for its cost of equity under the new capital structure. (13.1,14.8,18.9,16.4)

What will the firm’s weighted average cost of capital (WACC) be if it makes this change in its capital structure?

6.8%

8.9%

7.9%

10.5%

Answer 1