Question

Situational Software Co. (SSC) is trying to establish its optimal capital structure. Its current capital structure...

Situational Software Co. (SSC) is trying to establish its optimal capital structure. Its current capital structure consists of 35% debt and 65% equity; however, the CEO believes that the firm should use more debt. The risk-free rate, rRF, is 4%; the market risk premium, RPM, is 6%; and the firm's tax rate is 40%. Currently, SSC's cost of equity is 16%, which is determined by the CAPM.

What would be SSC's estimated cost of equity if it changed its capital structure to 50% debt and 50% equity? Round your answer to two decimal places. Do not round intermediate steps.

__________%

Homework Answers

Answer #1

Cost of Equity=Risk free return+Beta*market risk premium=16%

4%+beta*6%=16%

Beta=(16%-4%)/6%=12%/6%=2

Equity beta=Asset beta*(1+(1-tax rate)*Debt/Equity)

      =2*(1+(1-0.4)*35/65)

   =2*(1+(0.6*35/65))=2*(1+0.323077)

=2*1.323077=2.646154

New Asset Beta when Debt/Equity=50/50=1

Asset Beta=Equity Beta/(1+(1-tax rate)*Debt/Equity)

             =2.646154/(1+(1-0.4)*1)

              =2.646154/(1+0.6*1)=2.646154/1.6

          =1.653846

Cost of Equity=Risk free return+Beta*market risk premium=16%

=4%+1.653846*6%=13.92%

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