You have been called in as a consultant for Herbert€™s a sporting goods retail firm, which is examining its debt policy. The firm currently has a balance sheet as follows:

The firm€™s income statement is as follows:
Revenues .............. $250
Cost of goods sold (COGS) ...... $175
Depreciation ........... $25
EBIT .............. $50
Long-term interest .......... $10
EBT .............. $40
Taxes ............... $16
Net income ............ $24
The firm currently has 100 shares outstanding, selling at a market price of $5 per share and the bonds are selling at par. The firm€™s current beta is 1.12, and the risk-free rate is 7%.
a. What is the firm€™s current cost of equity?
b. What is the firm€™s current cost of debt?
c. What is the firm€™s current weighted average cost of capital?
d. Assume that management of Herbert€™s is considering doing a debt-equity swap (i.e., borrowing enough money to buy back seventy shares of stock at $5 per share). It is believed that this swap will lower the firm€™s rating to C and raise the interest rate on the company€™s debt to 15%.
e. What is the firm€™s new cost of equity?
f. What is the effective tax rate (for calculating the after-tax cost of debt) after the swap? What is the firm€™s new cost of capital?

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Liability Assets LT bonds $100 Fixed assets Equity Total $300 $300 Current assets $100 $400 $400 Total