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, rry, is 5%; the market risk premium, RPM, is 5%; and the firm's tax rate is 40%. Currently, SSC's cost of equity is 15%, 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.

Answer 1

Levered beta = 2.00 (0.15-0.05)/0.05 Unleverd beta = levered beta/ (1+(1-tax rate) x (D/E)] = 2/(1+(1-0.4) (0.25/0.75)] 1.67 Levered beta at debt 50% = unlevered beta x (1+(1-tax rate) x (D/E)] = 1.67 X (1+(1-0.4) x (0.5/0.5)] 2.667 Cost of equity = 18.33% 0.05+(2.667*0.05)