Question

Situational Software Co. (SSC) is trying to establish its optimal capital structure. Its current capital structure consists of 40% debt and 60% equity; however, the CEO believes that the firm should use more debt. The risk-free rate, rRF, is 6%; the market risk premium, RPM, is 6%; and the firm's tax rate is 40%. Currently, SSC's cost of equity is 12%, which is determined by the CAPM. The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the question below.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

Hello

Current cost of equity = Rf + (Beta x MRP)
​12% = 6% + (Beta x 6%)
Beta = 1

This is levered beta. We should now calculate Unlevered Beta.

Unlevered Beta = Levered Beta / [1 + (1-tax)(D/E)]
​= 1 / [1 + (1-0.40)(.40/.60)]
​= 0.7143

Now the capital structure changes to 50% debt and 50% equity. We will now calculate Levered Beta with 50% debt and 50% equity

Levered Beta = Unlevered Beta​ x [1 + (1-tax)(D/E)]
​= 0.7143 x [1 + (1-0.40)(0.50/0.50)]
​= 1.14288

New levered Beta = 1.14288

New cost of equity will be = Rf + (New levered beta x MRP)

= 6% + (1.14288 x 6)
​= 12.86%

I hope this solves your query.

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