Cyclone Software Co. is trying to establish its optimal capital structure. Its c

Question

Cyclone Software Co. is trying to establish its optimal capital structure. Its current capital structure consists of 25 percent debt and 75 percent equity; however, the CEO believes that the firm should use more debt. The risk-free rate, rRF, is 5 percent; the market risk premium, RPm, is 6 percent; and the firm's tax rate is 40 percent. Currently, Cyclone's cost of equity is 14 percent, which is determined by the CAPM. What would be Cyclone's estimated cost of equity if it changed its capital structure to 50 percent debt and 50 percent equity?

Explanation / Answer

Cost of Equity = Riskfree rate + (Market Risk Premium)(Leveraged Beta) 14 = 5% + (6%)(Beta leveraged at 25% Debt) Beta leveraged for 25% Debt = 1.5 Unleveraged Beta = (Leveraged Beta)/[1+(1-T)(D/E)] = 1.5/[1+(1-40%)(25%/75%)] = 1.25 Beta leveraged at 50% Debt = 1.25x[1+(1-40%)(50%/50%)] = 2 Cost of equity, rs= Riskfree rate + (Market Risk Premium)(Beta leveraged at 50% Debt) = 5% + (6%)(2) = 17%

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.