Question

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, r_RF, is 4%; the market risk premium, RP_M, 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.

__________%

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%