Question

Cyclone Software Co. is trying to establish its optimal capital structure. Its current capital structure consists...

Cyclone Software Co. is trying to establish its optimal capital structure. Its current capital structure consists of 20% debt and 80% equity; however, the CEO believes the firm should use more debt. The risk-free rate, rRF, is 5%; the market risk premium, RPM, is 5%; and the firm's tax rate is 40%. Currently, Cyclone's cost of equity is 13%, which is determined by the CAPM.

What would be Cyclone's estimated cost of equity if it changed its capital structure to 50% debt and 50% equity? Round your answer to two decimal places.

Homework Answers

Answer #1

Given information

current structure Equity 80% and debt 20%

risk free rate 5%

risk premium 5%

tax rate 40%

current cost of equity- 13%

First we will calculate current beta

Cost of equity = risk free rate+ beta* risk premium

=13=5+beta*5 =beta =1.6

now we will calculate unlevered beta-

= levered beta/(1+(1- tax)(debt/equity))

=1.6/(1+(0.60*(.20/.80) =1.39

Now beta under new capital structure

=beta unlevered*(1+(1- tax)(debt/equity)

=1.39*(1+(0.60*(.50/.50) = 2.22

Thus new cost of equity = risk free rate+ new beta*risk premium

=5+2.22*5 = 16.10%

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