Question

Situational Software Co. (SSC) is trying to establish its optimal capital structure. Its current capital structure consists of 40% debt and 60% equity; however, the CEO believes that the firm should use more debt. The risk-free rate, rRFᵣ , is 5%; the market risk premium, RPM, is 5\%; and the firm's tax rate is 40%. Currently, SSC's cost of equity is 14%, 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

To calculate the new cost of equity for SSC when changing its capital structure to 50% debt and 50% equity, one would need information about the company's beta or debt's impact on the firm's risk profile, which is not provided.

Step-by-step explanation:

The student's question seeks to determine the estimated cost of equity after a change in the capital structure of Situational Software Co. (SSC), from 40% debt and 60% equity to an equal distribution of 50% debt and 50% equity. The current cost of equity calculated using the Capital Asset Pricing Model (CAPM) is 14%, given a risk-free rate of 5% and a market risk premium of 5%. Additionally, the company's tax rate is at 40%. When changing the capital structure to 50% debt and equity, it can affect the cost of equity due to the change in a firm's perceived risk. However, to calculate the new cost of equity, one would typically need to know the company's beta or have additional information about the effect of leverage on the company's risk profile. Without details on SSC’s beta or how debt impacts the firm's risk, the exact number cannot be calculated from the given data.