Question

Situational Software Co. (SSC) is trying to establish its optimal capital structure. Its current capital structure consists of 20% debt and 80% equity; however, the CEO believes that the firm should use more debt. The risk-free rate, RF, is 6%; 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. The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the question below. Open spreadsheet What would be SSC's estimated cost of equity if it changed its capital structure to 50% debt and 50% equity? Round your answer to two decimal places. Do not round intermediate steps.

Answer 1

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

1 2 3 Original % debt in capital stucture,wd 4. Original % common equity in capital stucture,wc 5 Risk free rate 6 Market risk premium 7 Tax rate 8 Firm's cost of equity 9 10 11 Firm's current beta 12 20.00% 80.00% 6.00% 5.00% 40.00% 15.00% Formulas 1.80 = (B8-B5/B6 13 1.57 =B11/(1+(B3/B4)*(1-B7)) 50.00% 50.00% 14 Firm's unlevered beta 15 16 New % of debt in capital sturcture, wd new 17 New % of common equity in capital sturcture, wc new 18 19 20 Firm's new beta 21 22 23 Firm's new cost of equity 24 2.50 =B14*(1+(B16/B17)*(1-B7)) 18.52% =B5+B6*B20

Cell reference -

3 Original % debt in capital stucture,wd 4 Original % common equity in capital stucture, wc 5 Risk free rate 6 Market risk premium 7 Tax rate 8 Firm's cost of equity 9 0.2 0.8 0.06 0.05 0.4 0.15 Formulas 10 1 =(B8-B5/B6 =FORMULATEXT(B11) =B11/(1+(B3/B4)*(1-B7)) =FORMULATEXT(B14) 11 Firm's current beta 12 13 14 Firm's unlevered beta 15 16 New % of debt in capital sturcture, wd new 17 New % of common equity in capital sturcture, wc new 18 19 20 Firm's new beta 21 0.5 0.5 =B14*(1+(B16/B17)*(1-B7)) =FORMULATEXT(B20) 22 23 Firm's new cost of equity =B5+B6*B20 =FORMULATEXT(B23) 24 25 25

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