A small, private firm has approached you for advice on its capital structure decision. It is in the specialty retailing business, and it had earnings before interest and taxes last year of $ 500,000.

The book value of equity is $1.5 million, but the estimated market value is $ 6 million.

The firm has $ 1 million in debt outstanding, and paid an interest expense of $ 80,000 on the debt last year. (Based upon the interest coverage ratio, the firm would be rated AA, and would be facing an interest rate of 8.25%.)

The equity is not traded, but the average beta for comparable traded firms is 1.05, and their average debt/equity ratio is 25%.

a) Estimate the current cost of capital for this firm.

b) Assume now that this firm doubles it debt from $1million to $2million, and that the interest rate at which it can borrow increases to 9%. Estimate the new cost of capital, and the effect on firm value