Question

Situational Software Co. (SSC) is trying to establish its optimal capital structure. Its current capital structure consists of 35% debt and 65% equity; however, the CEO believes that the firm should use more debt. The risk-free rate, rRF, is 5%; the market risk premium, RPM, is 7%; and the firm's tax rate is 25%. 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

Please refer to below spreadsheet for calculation and answer. Cell reference also provided.

Current Capital Structure Debt Equity Cost of Equity Risk free rate Market risk premium Tax rate 35% 65% 15% 5% 7% 25% Current Equity Beta (Levered Beta) 1.43 12 Unlevered Beta 1.018 New Capital Structure Debt Equity 50% 50% New Equity beta (levered beta) 1.78 New estimated cost of equity 17.47%

Cell reference -

A Current Capital Structure Debt Equity Cost of Equity Risk free rate Market risk premium Tax rate 0.35 0.65 0.15 0.05 0.07 0.25 Current Equity Beta (Levered Beta) =(C5-C6)/C7 Unlevered Beta =C10/(1+(1-C8)*C3/04) New Capital Structure 15 Debt 0.5 Equity 0.5 New Equity beta (levered beta) =C12*(1+(1-C8)*C15/016) New estimated cost of equity =C6+C18*C7

Hope this will help, please do comment if you need any further explanation. Your feedback would be highly appreciated.