You are helping the CFO of a steel company assess whether the firm should embark

on a plan to reduce its financial leverage. The firm currently has equity with a market

value of $ 400 million and debt outstanding (in market value terms) of $ 600 million.

The cost of equity currently is 13% and the pre-tax cost of borrowing is 9%. (The

riskfree rate is 5% , the tax rate is 40% and the equity risk premium is 4%)

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

b. The firm plans to issue new stock and retire half of its existing debt. If the pretax

cost of borrowing will drop to 6% as a consequence, estimate the cost of

capital after the recapitalization.