496 CHAPTER 13 Capital Structure Decisions
Note that beta is the only variable that can be influenced by management in the
CAPM cost of equity equation, rs(rRFRPM)b. The risk-free rate and market risk
premium are determined by market forces that are beyond the firm’s control. However,
b is affected (1) by the firm’s operating decisions as discussed earlier in the chapter,
which affect bU, and (2) by its capital structure decisions as reflected in its D/S ratio.
As a starting point, a firm can take its current beta, tax rate, and debt/equity ratio
and calculate its unlevered beta, bU,by simply transforming Equation 13-8 as follows:
bUb/[1 (1 T)(D/S)]. (13-8a)
Then, once bUis determined, the Hamada equation can be used to estimate how
changes in the debt/equity ratio would affect the leveraged beta, b, and thus the cost
of equity, rs.
We can apply the procedure to Strasburg Electronics. First, the risk-free rate of
return, rRF, is 6 percent, and the market risk premium, RPM, is 6 percent. Next, we
need the unlevered beta, bU. Because Strasburg has no debt, its D/S 0. Therefore,
its current beta of 1.0 is also its unlevered beta, hence bU1.0. Therefore, Stras-
burg’s current cost of equity is 12 percent:
rsrRFRPM(b)
6% (6%)(1.0)
6% 6% 12%.
The first 6 percent is the risk-free rate, the second the risk premium. Because Stras-
burg currently uses no debt, it has no financial risk. Therefore, its 6 percent risk
premium reflects only its business risk.
If Strasburg changes its capital structure by adding debt, this would increase the
risk stockholders bear. That, in turn, would result in an additional risk premium.
Conceptually, this situation would exist:
rsrRFPremium for business risk Premium for financial risk.
Column 4 of Table 13-3 shows Strasburg’s estimated beta for the capital structures
under consideration .Figure 13-4 (using data calculated in Column 5 of Table 13-3)
graphs Strasburg’s required return on equity at different debt ratios. As the figure
shows, rsconsists of the 6 percent risk-free rate, a constant 6 percent premium for
business risk, and a premium for financial risk that starts at zero but rises at an in-
creasing rate as the debt ratio increases.
3. Estimating the Weighted Average Cost of Capital, WACC
Column 6 of Table 13-3 shows Strasburg’s weighted average cost of capital, WACC, at
different capital structures. Currently, it has no debt, so its capital structure is 100 per-
cent equity, and at this point WACC rs12%. As Strasburg begins to use lower-
cost debt, the WACC declines. However, as the debt ratio increases, the costs of both
debt and equity rise, at first slowly but then at a faster and faster rate. Eventually, the
increasing costs of the two components offset the fact that more low-cost debt is being
used. At 40 percent debt, the WACC hits a minimum of 10.8 percent, and after that it
rises with further increases in the debt ratio.
Note too that even though the component cost of equity is always higher than that
of debt, using only lower-cost debt would not maximize value because of the feedback
effects on the costs of debt and equity. If Strasburg were to issue more than 40 percent
debt, it would then be relying more on the cheaper source of capital, but this lower
cost would be more than offset by the fact that using more debt would raise the costs
of both debt and equity.
492 Capital Structure Decisions
