Hugo Boss AG is a German luxury fashion and style house that is examining its financing policy for possible changes. The firm has 8-year coupon bonds outstanding with a face value of $ 400 million and interest expenses of $18.0 million a year. This is the only debt obligation, the company has. The firm is rated BB and the default spread (on top of risk free rate) for BB rated bonds is 4%. There are 20 million shares trading at $10 a share and the current levered beta for the firm is 1.80. The risk-free rate is 3% and the market risk premium is 6%. The corporate tax rate for the firm is 40%.
Questions:
a. Estimate the current market value of debt and equity today.
b. Estimate the current cost of capital for the firm.
c. The company believes that it could lower it’s cost of capital by moving to debt to capital (D/A) ratio of 50%. The company predicts that this move could lower it’s pre-tax cost of capital by 1.5 percentage points. Calculate the new cost of capital for the company given that the change in capital structure is undertaken (note that you’ll have to unlever and relever your equity beta to find the final answer).