Question

Hamada equation

Cyclone Software Co. is trying to establish its optimal capital structure. Its current capital structure consists of 30% debt and 70% equity; however, the CEO believes 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, Cyclone's cost of equity is 15%, 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.

%

Answer 1

D/A =0.3

D/E=D/(A-D)=0.3/(1-0.3)=0.4286

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

15 = 4 + Beta * (5)

Beta = 2.2

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

2.2 = Unlevered Beta*(1+((1-0.4)*(0.4286)))

Unlevered Beta = 1.75

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

levered beta = 1.75*(1+((1-0.4)*(1)))

levered beta = 2.8

D/A =0.5

D/E=D/(A-D)=0.5/(1-0.5)=1

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 4 + 2.8 * (5)

Expected return% = 18