Adam’s Software Co. is trying to estimate its optimal capital structure. Right now, Adman has a capital structure that consists of 20% debt and 80% equity. (Its D/E ratio is 0.25.) %. Currently the company’s cost of equity is 12% and its tax rate is 40%. The risk-free rate is 6% and the market risk premium is 5%.
What would be Adam’s estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?
| D/A = | |||||||||
| D/E=D/(A-D)=0.2/(1-0.2)=0.25 | |||||||||
| As per CAPM | |||||||||
| expected return = risk-free rate + beta * (Market risk premium) | |||||||||
| 12 = 6 + Beta * (5) | |||||||||
| Beta = 1.2 | |||||||||
| Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity))) | |||||||||
| 1.2 = Unlevered Beta*(1+((1-0.4)*(0.25))) | |||||||||
| Unlevered Beta = 1.04 | |||||||||
| 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 = 1.04*(1+((1-0.4)*(1))) | |||||||||
| levered beta = 1.66 | |||||||||
| As per CAPM | |||||||||
| expected return = risk-free rate + beta * (Market risk premium) | |||||||||
| Expected return% = 6 + 1.66 * (5) | |||||||||
| Expected return% = 14.3 |
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