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 6%; the market risk premium, RPM, is 5%; and the firm's tax rate is 40%. Currently, SSC's cost of equity is 13%, 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.

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Answer 1

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

A B с 1 Risk free rate Market risk premium Tax rate 6% 5% 40% Current capital structure Debt Equity Cost of equity 35% 65% 13% Current Equity Beta (levered) 1.40 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 Unlevered Beta 1.06 New Capital Structure Debt Equity New levered Beta 50% 50% 1.69 New Estimated Cost of equity 14.47% 23

Cell reference -

G13 A B C 1 2 Risk free rate Market risk premium Tax rate 0.06 0.05 0.4 Current capital structure Debt Equity Cost of equity 0.35 0.65 0.13 Current Equity Beta (levered) =(C9-C2)/C3 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Unlevered Beta =C11/(1+(07/08)*(1-C4)) 0.5 New Capital Structure Debt Equity New levered Beta 0.5 =C13*(1+(C17/C18)*(1-C4)) New Estimated Cost of equity =C2+C3*C19 21 22 23

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