Question Tag: Risk-free rate

i) Cost of capital for the quarry if the company maintains its current capital structure:

The current capital structure of Oheneba Limited consists of GH¢100,000 in equity and GH¢35,000 in debt, so the debt-to-equity ratio is 0.35 (35/100).

We are given:

• Industry beta: 1.6
• Equity-to-debt ratio: 2:1
• Tax rate: 30%
• Long-term debt yield: 10% (risk-free)
• Average return on the stock market: 15%
• Company’s equity beta: 1.2

Ungearing the beta:
We first need to ungear the beta using the formula:

Next, we need to gear the beta for Oheneba Limited’s capital structure using the same formula:

ow, we can calculate the cost of equity ($Ke$) using the Capital Asset Pricing Model (CAPM):

Ke=Rf+Be⋅(Rm−Rf)

Where:

• $10\%$ (risk-free rate)
• $15\%$ (market return)

Thus, the cost of capital for Oheneba Limited if it maintains its current capital structure is 14.7%.

ii) Cost of capital for the quarry if the company changes its capital structure to 20% debt and 80% equity:

We already know the asset beta ($Ba=1.19$).

Now we need to regear the beta for the new capital structure (20% debt and 80% equity):