Globex Corp. is an all-equity firm, and it has a beta of 1. It is considering changing its capital structure to 70% equity and 30% debt. The firmās cost of debt will be 8%, and it will face a tax rate of 40%.
What will Globex Corp.ās beta be if it decides to make this change in its capital structure? 1.26
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 8%, and its tax rate is 40%. It currently has a levered beta of 1.25. The risk-free rate is 3.5%, and the risk premium on the market is 8%.
U.S. Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity. Increasing the firmās level of debt will cause its before-tax cost of debt to increase to 10%. Use the Hamada equation to unlever and relever the beta for the new level of debt. What will the firmās weighted average cost of capital (WACC) be if it makes this change in its capital structure? (Hint: Do not round intermediate calculations.)
The optimal capital structure is the one that the WACC and the firmās stock price. Higher debt levels the firmās risk. Consequently, higher levels of debt cause the firmās cost of equity to .