Facts as given: Current capital structure: 25% debt, 75% equity; r_RF = 4%; Market Risk Premium=r_M r_RF = 5%; Tax rate = 25%; r_s under this current capital structure= 12%.

What would be the new cost of equity if the company changed its capital structure to 40% debt and 60% equity?

Step 1: Determine the firms current beta.

r_s = r_RF + (r_M r_RF)b

Step 2: Determine the firms unlevered beta, b_U.

b_U = b_L/[1 + (1 T)(D/E)]

=

Step 3: Determine the firms beta under the new capital structure.

b_L = b_U[1 + (1 T)(D/E)]

Step 4: Determine the firms new cost of equity under the changed capital structure.

r_s = r_RF + (r_M r_RF)b