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%