Question

HAMADA EQUATION Situational Software Co. (SSC) is trying to establish its optimal capital structure. Its current capital structure consists of 30% debt and 70% equity; however, the CEO believes that the firm should use more debt. The risk-free rate, ref, is 4%; the market risk premium, RPM, is 7%; 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? Round your answer to two decimal places. Do not round intermediate steps.

Answer 1

Using CAPM Model,

Cost of Equity = Rf + Beta(Market Risk Premium)

0.15 = 0.04+ Beta(0.07)

Beta = 1.57

Unlevered Beta = Beta/(1 + (1 - t)(D/E))

Unlevered Beta = 1.57/(1 + (1 - 0.40)(0.30/0.70))

Unlevered Beta = 1.25

New Capital Structure has Debt = 50% and Equity = 50%

Levered Beta = 1.25(1 + (1 - 0.40)(0.50/0.50)]

Levered Beta = 2.00

New cost of Equity = 0.04 + 2(0.07)

New Cost of Equity = 18.00%