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, rRF, is 4%; the market risk premium, RPM, is 6%; 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

Answer 1

Answer:the Cost of equity when the capital structure is changed to  50% debt and 50% equity  is 16.546%..

Explanation:

Let the Beta be x

Cost of equity (CAPM) = risk free rate + Beta (Market risk premium)

15% = 4% + x (6%)

15%-4% = x (6%)

11% = 6%x

 x = Beta =11%/6%=1.83

Debt Equity ratio

= Debt /Equity

=40% ÷ 60%

= 0.667

Beta levered = Beta unlevered [1 + (1 - tax rate) Debt equity ratio]

1.83= Beta Unlevered [1 + (1 - 40%) × 0.667)]

1.83= Beta Unlevered [1 +60% x 0.667)

1.83= Beta Unlevered (1.4002)

Beta unlevered = 1.83/1.4002=1.3069

Now when debt =50% and equity = 50%

The Beta at new required capital structure  would be  

Debt Equity ratio

= Debt ÷ Equity

=50% /50%

= 1

Beta levered = Beta unlevered (1 + (1 - tax rate) Debt equity ratio)

Beta levered = 1.3069 (1 + (1 - 40%) × 1)

Beta levered = 1.3069(1 +0.6

Beta levered = 2.09104

CAPM Cost of equity = risk free rate + Beta ( Market risk premium)

Cost of equity = 4% +  2.09104 (6%)

Cost of equity = 13.04%

Therefore,  the Cost of equity when the capital structure is changed to  50% debt and 50% equity  is 16.546%.