THIS IS MY 3RD TIME POSTING THIS QUESTION. THE ANSWER IS NOT 5.60 OR 18.26... TH

Question

THIS IS MY 3RD TIME POSTING THIS QUESTION. THE ANSWER IS NOT 5.60 OR 18.26... THANKS

Cyclone Software Co. is trying to establish its optimal capital structure. Its current capital structure consists of 30% debt and 70% equity; however, the CEO believes the firm should use more debt. The risk-free rate, rRF, is 3%; the market risk premium, RPM, is 7%; and the firm's tax rate is 40%. Currently, Cyclone's cost of equity is 16%, which is determined by the CAPM. What would be Cyclone's estimated cost of equity if it changed its capital structure to 50% debt and 50% equity? Round your answer to two decimal places.

%

Explanation / Answer

Assuming cost of debt = 3% (Risk free rate ,as Debt is always risk free)

At present :

WACC = After tax debt *Weight of debt    +   Cost of equity *Weight of equity

         = 3 (1-.40 ) * .30             + 16 *.70

       = 1.8 *.30   + 11.2

       = .54 +11.2

        = 11.74 %

Now ,If company want to maintain same WACC,but capital structure changes,

11.74 = 1.8(1-.40 )*.50 +    X*.50

11.74 = .90   + .50x

.50X   = 11.74 -.90

.50X =    10.84

X(Cost of equity ) = 10.84 /.50

                          = 21.68 %

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