Question

Situational Software Co. (SSC) is trying to establish its optimal capital structure. Its current capital structure consists of 25% debt and 75% equity; however, the CEO believes that the firm should use more debt. The risk-free rate, r_RF, is 5%; the market risk premium, RP_M, is 7%; and the firm's tax rate is 40%. Currently, SSC's cost of equity is 14%, 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

Step 1: Determine the firm’s current beta.

ks = kRF+ (kM– kRF)b

14% = 5% + (7%)b

9% = 7%b

1.29 = b.

Step 2 : Determine the firm’s unlevered beta, bU.

bU = bL/[1 + (1 – T)(D/E)]

= 1.29/[1 + (1 – 0.4)(0.25/0.75)]

= 1.29/1.20 = 1.07.

Step 3 : Determine the firm’s beta under the new capital structure.

bL = bU(1 + (1 – T)(D/E))

= 1.07[1 + (1 – 0.4)(0.5/0.5)] = 1.07(1.6) = 1.71.

Step 4 : Now, estimate the ke with the new beta

ke = 5% + [7% x 1.71] = 5% + 12% = 17%