Answer Happy

The CEO of Obelix Ltd, a utility firm specializing in supplying green energy to households, is interested in the impact of adjusting the firm's borrowing policy to improve its financial strength in light of the competition in the energy sector. The CEO asks you to provide a report that you will present to the board to offer workable financial policies for the firm. The following table details the firm's current balance sheet. Note that there is no information about the cost of equity capital. Value Cost of capital Total assets £120m 10% Debt £40m 4% Equity £80m ? The CEO realizes that by increasing the firm's debt burden, the cost of debt capital will rise as there is an increase in the bankruptcy risk of the firm. The following table estimates the link between the debt-equity ratio and the cost of debt capital. Debt-Equity ratio Cost of debt 1/2 4.00% 5/7 4.02% 6/6 4.05% 775 4.10% 8/4 4.50% The market data are as follows: The risk-free rate The average retum on the market index 3% 7% Your report should address the following points. w) What is the current cost of equity capital? (5 marks) b) Work out the cost of cquity for a debt-equity ratio of one, as well as a debt-equity ratio of two. State the assumptions you make. (10 marks)