Morales publishing's tax rate is 40%, its beta is 1.10, and it uses no debt. however, the cfo is considering moving to a capital structure with 30% debt and 70% equity. if the risk-free rate is 5.0% and the market risk premium is 6.0%, by how much would the capital structure shift change the firm's cost of equity?

change in equity cost is  1.70%

Step-by-step explanation:

given data

tax rate T = 40%

beta b =  1.10

debt D = 30%

equity E = 70%

risk-free rate RR = 5.0%

risk premium RP = 6.0%

to find out

the capital structure shift change the firm cost of equity

solution

we know here debt and equity so

Target D/E will be =    

Target D/E = 0.43

levered beta = beat ( 1 + D/E × (1 - tax rate) )

levered beta = 1.10 ( 1 + 0.43 × (1 - 40%) )

levered beta =  1.3828571  

and

cost of equity unlevered  = risk-free rate + beta (risk premium)

cost of equity unlevered  = 5% + 1.1 (6%)  = 11.60%

and

cost of equity levered = risk-free rate + levered beta (risk premium)

cost of equity levered = 5% + 1.38 (6%) =  13.30%

so change in equity cost will be  =  13.30% - 11.60%

change in equity cost is  1.70%