Globo-Chem Co. currently has a capital structure consisting of 30% debt and 70% equity. However, Globo-Chem Co.'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 8%, and Globo-Chem Co.'s beta is 1.10. If the firm's tax rate is 25%, what will be the beta of an all-equity firm if its operations were exactly the same? Now consider the case of another company: US Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 6%, and its tax rate is 25%. It currently has a levered beta of 1.10. The risk-free rate is 3.5%, and the risk premium on the market is 8%. US 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 8%. First, solve for US Robotics Inc.'s unlevered beta. Use US Robotics Inc.'s unlevered beta to solve for the firm's levered beta with the new capital structure. Use US Robotics Inc.'s levered beta under the new capital structure, to solve for its cost of equity under the new capital structure. What will the firm's weighted average cost of capital (WACC) be if it makes this change in its capital structure? 10.07% 8.48% 10.60% 7.95%
Globo-Chem Co. currently has a capital structure consisting of 30% debt and 70% equity. However, Globo-Chem Co.'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 8%, and Globo-Chem Co.'s beta is 1.10. If the firm's tax rate is 25%, what will be the beta of an all-equity firm if its operations were exactly the same? Now consider the case of another company: US Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 6%, and its tax rate is 25%. It currently has a levered beta of 1.10. The risk-free rate is 3.5%, and the risk premium on the market is 8%. US 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 8%. First, solve for US Robotics Inc.'s unlevered beta. Use US Robotics Inc.'s unlevered beta to solve for the firm's levered beta with the new capital structure. Use US Robotics Inc.'s levered beta under the new capital structure, to solve for its cost of equity under the new capital structure. What will the firm's weighted average cost of capital (WACC) be if it makes this change in its capital structure? 10.07% 8.48% 10.60% 7.95%
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:Globo-Chem Co. currently has a capital structure consisting of 30% debt and 70% equity.
However, Globo-Chem Co.'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 8%, and Globo-Chem
Co.'s beta is 1.10.
If the firm's tax rate is 25%, what will be the beta of an all-equity firm if its operations were
exactly the same?
Now consider the case of another company:
US Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current
before-tax cost of debt is 6%, and its tax rate is 25%. It currently has a levered beta of
1.10. The risk-free rate is 3.5%, and the risk premium on the market is 8%. US 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 8%.
First, solve for US Robotics Inc.'s unlevered beta.
Use US Robotics Inc.'s unlevered beta to solve for the firm's levered beta with the new capital
structure.
Use US Robotics Inc.'s levered beta under the new capital structure, to solve for its cost of equity
under the new capital structure.
What will the firm's weighted average cost of capital (WACC) be if it makes this change in its
capital structure?
10.07%
8.48%
10.60%
7.95%
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