Simon Software Co. is trying to estimate its optimal capital structure. Right no

Question

Simon Software Co. is trying to estimate its optimal capital structure. Right now, Simon has a capital structure that consists of 20% debt and 80% equity, based on market values. (Its D/S ratio is 0.25.) The risk-free rate is 6% and the market risk premium, rM - rRF, is 5%. Currently the company's cost of equity, which is based on the CAPM, is 12% and its tax rate is 40%. What would be Simon's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity? Answer 13.00% 13.64% 14.35% 14.72% 15.60%

Explanation / Answer

given: rs = 12%; D/E = 0.25; rRF = 6%; RPM = 5%; T = 40%. Step 1: Find the firms current levered beta using the CAPM: rs = rRF + RPM(b) 12% = 6% + 5%(b) beta = 1.2 Step 2: Find the firms unlevered beta using the Hamada equation: b = bU[1 + (1 - T)(D/E)] 1.2 = bU[1 + (0.6)(0.25)] 1.2 = 1.15bU 1.0435 = bU. Step 3: Find the new levered beta given the new capital structure using the Hamada equation: b = bU[1 + (1 - T)(D/E)] b = 1.0435[1 + (0.6)(1)] b = 1.6696 Find the firms new cost of equity given its new beta and the CAPM: rs = rRF + RPM(b) rs = 6% + 5%(1.6696) rs = 14.35%. Answer:14.35%

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