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Test your understanding 2
Moondog Co is a company with 20:80 debt:equity ratio. Using CAPM, its cost of equity has been calculated as 12%.
It is considering raising some debt finance to change its gearing ratio to 25:75 debt to equity. The expected return to debt holders is 4% per annum, and the rate of corporate tax is 30%.
Required:
Calculate the theoretical cost of equity in Moondog Co after the refinancing
I don’t have the Kaplan study text, but surely they have an answer to the problem?
You first need to use the M&M proposition 2 formula from the formula sheet to calculate the cost of equity if no gearing. Then you need to use the same formula again to calculate the cost of equity with the new gearing.
Then you can calculate the WACC as normal.
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