Question

Situational Software Co. (SSC) is trying to establish its
optimal capital structure. Its current capital structure consists
of 20% debt and 80% 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 5%; 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? Do not round intermediate calculations. Round your answer
to two decimal places.

Answer #1

What would be SSC's estimated cost of equity if it changed its capital structure to 50% debt and 50% equity?

=risk free rate+relevered beta*market risk premium

=risk free rate+levered beta/(1+(1-tax rate)*Debt/Equity)*(1+(1-tax rate)*Debt/Equity)*market risk premium

=risk free rate+(cost of equity-risk free rate)/market risk
premium*1/(1+(1-tax rate)*Debt/Equity)*(1+(1-tax
rate)*Debt/Equity)*market risk premium

=4%+(16%-4%)/5%*1/(1+(1-40%)*20%/80%)*(1+(1-40%)*50%/50%)*5%

=20.70%

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