Finance

Problem 5-2PROBLEM 5-2GivenSolution LegendDebt Ratio (current)30.0%= Value given in problemEquity Ratio (current)70.0%= Formula/Calculation/Analysis requiredCost of Debt6.0%= Qualitative analysis or Short answer requiredMarket Risk Premium5.25%= Goal Seek or Solver cellEquity Beta1.20= Crystal Ball InputDebt Beta0.29= Crystal Ball OutputRisk Free Rate4.5%Corporate Tax Rate0.35Solutiona. Cost of Equity10.80%b. WACC8.73%c.Unlevered beta (current debt levels)0.94Revised Equity Beta1.35Cost of Equity11.56%Debt Ratio40.0%Equity Ratio60.0%Revised WACC8.50%

Note: This analysis presumes that the cost of debt financing is "sticky" in the sense that it varies in a discrete fashion with the firm's bond rating. In other words, even though the firm has increased its use of financial leverage from 35 to 40% the cost of debt (and the debt beta) do not change.bOn the other hand, the cost of equity does change since the higher leverage implies a higher equity beta.