Question

# Situational Software Co. (SSC) is trying to establish its optimal capital structure. Its current capital structure...

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, rRF, is 4%; the market risk premium, RPM, 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.

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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