Question

Situational Software Co. (SSC) is trying to establish its optimal capital structure. Its current capital structure consists of 20% debt and 80% equity; however, the CEO believes that the firm should use more debt. The risk-free rate, rRF, is 5%; the market risk premium, RPM, is 6%; and the firm's tax rate is 40%. Currently, SSC's cost of equity is 12%, 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

As per CAPM,
Required rate of return= Rf + (market risk premium*Beta)
Rf=Risk free interest		Rf=5%		Beta=
Market risk premium =		6.00%
Cost of equity(%)=	5+(6*beta)
12=	5+(6*beta)
beta unlevered	1.17

Levered Beta(Be)=	Unlevered Beta(Bu)*(1+(Debt/equity))
So Bu=	Be/(1+(debt/equity))

So Be=	Bu*(1+(debt/equity))
=	1.17*(1+(0.2/0.8))
=	1.46
Calculation of Bu if proportion of debt and equity changes
So Bu=	Be/(1+(debt/equity))
=	1.46/(1+(0.5/0.5))
=	0.73

Now calculation of cost of equity when debt and equity are 50% each:

As per CAPM,
Required rate of return= Rf + (market risk premium*Beta)
Rf=Risk free interest		Rf=5%		Beta=0.73
Market risk premium =		6.00%
Cost of equity(%)=	5+(6*0.73)
=	9.38