You have the following initial information on which to base your calculations and discussion:

• Debt yield = 2.6%
• Required Rate of Return on Equity = 12%
• Expected return on S&P500 = 10%
• Risk-free rate (rF) = 1.5%
• Inflation = 2.5%
• Corporate tax rate (TC) = 30%
• Current long-term and target debt-equity ratio (D:E) = 1:3

a. What is the unlevered cost of equity (rE*) for this firm? (8 marks)

Assume that the management of the firm is considering a leveraged buyout of the above company. They believe that they can gear the company to a higher level due to their ability to extract efficiencies from the firm’s operations. Thus, they wish to use a target debt-equity ratio of 3:1 in their valuation calculations.

b. What would the levered cost of equity equal for this firm at a debt-equity ratio (D:E) of 3:1? (4 marks)

c. What would the required rate of return for the company equal if it were to be acquired under the leveraged buyout structure (i.e., what would the estimated firm WACC equal to under a debt-equity ratio of 3:1)? (3 marks)