Question

Cyclone Software Co. is trying to establish its optimal capital structure. Its current capital structure consists of 40% debt and 60% 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 16%, 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 =0.4

D/E=D/(A-D)=0.4/(1-0.4)=0.6667

As per CAPM

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

16 = 4 + Beta * (5)

Beta = 2.4

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

2.4 = Unlevered Beta*(1+((1-0.4)*(0.6667)))

Unlevered Beta = 1.71

D/A =0.5

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

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

levered beta = 1.71*(1+((1-0.4)*(1)))

levered beta = 2.74

As per CAPM

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

Expected return% = 4 + 2.74 * (5)

Expected return% = 17.7