Problem
Lister Inc. is a small, publicly traded data processing company that has $200 million in debt outstanding, in both book value and market value terms. The book value of equity in the company is S400 million and there are 40 million shares outstanding, trading at SZOI'share. The current levered beta for the company is 1.15 and the company's pre-tax cost of borrowing is 5%. The current risk-free rate in US $ is 3%, the equity risk premium is 5% and the marginal tax rate is 40%.
1. Estimate the current cost of capital for the company.
2. Now assume that the company plans to triple its debt to capital ratio (through a recapitalization), which will raise the pre-tax cost of debt to 8%. If the expected pre-tax operating income of the firm is $36 million, estimate the new cost of capital.