Simon Software Co is in inn to estimate its optimal capital structure. Right now

Question

Simon Software Co is in inn to estimate its optimal capital structure. Right now, Simon has a capital structures that consists of 20 percent debt and 80 percent equity. (Its D/E ratio is 0.25.) The risk-free rate is 6 percent and the market risk premium, k_m - k_RF, is 5 percent. Currently the company's cost of equity, which is based on the CAPM, is 12 percent and its tax rate is 40 percent. What would be Simon's estimated cost of equity if it were to change its capital structures to 50 percent debt and 50 percent equity?

Explanation / Answer

Cost of equity does not change with increase or decrease in equity capital. But, weighted average cost of capital (WACC) will change as the weights of debt and equity will change. It is also said by the net income approach of capital structure theory.

If,

Ke = Cost of Equity

Kd = Cost of Debt

T = Tax Rate

D = Debt Capital

E = Equity Capital

Then,

WACC = Ke*(E/(D+E)) + Kd*(D/(D+E))*(1-T)

Thus, with the change in Debt and equity capital, WACC changes.

Though, there is another theory that is named as “net income approach” . It says that WACC does not change and Ke adjusts with increase and decrease in debt capita. To calculate this, we need WACC as well as Kd. Value of WACC and Kd is not given in the question.

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