Question

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, rRF, is 6%; 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

The estimated cost of equity is 10.3%

Step-by-step explanation:

Step 1: Find Levered Beta

The CAPM formula would be used here to find the Levered Beta. CAPM formula is given as under:

Ke = Rf + Beta * (MRP - Rf)

Current Cost of Equity of company is ke and is 15%,

Risk free rate is Rf and is 6%

Market risk premium is 7%

15% = 6% + Beta* (7% - 6%)

Levered Beta = 9

Step 2: Find the Unlevered Beta

As we know that existing Debt to Equity ratio is (30 / 70), we can use the following formula to calculate the unlevered beta:

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

Simply by putting values, we have:

Unlevered Beta = 1.2 / (1 + (1 - 40%) * 30/70) = 7.16

Step 3: Calculate levered beta on new debt to equity ratio

Now

New Debt to Equity Ratio is 1 (50 / 50)

As we know that:

Levered Beta = Unlevered Beta * (1 + (1-t) * Debt / Equity)

Levered Beta = 7.16 * (1 - 40%) * 1) = 4.3

Step 4: Use CAPM formula to calculate Cost of equity on new gearing

Using CAPM formula, we have:

Ke = Rf + Beta * (MRP - Rf)

Ke = 6% + 4.3 * 1% = 10.3%