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 40% debt and 60% equity; however, the CEO believes the firm should use more debt. The risk-free rate, rRF, is 6%; the market risk premium, RPM, is 5%; and the firm's tax rate is 40%. Currently, Cyclone's cost of equity is 12%, 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

First we need to compute levered beta using CAPM:

Re = Rf + MRP x beta

0.12 =0.06+0.05 x beta

Beta =1.20

Unlevered beta at given D/E ratio (0.40/0.60 =0.6667)

Unlevered Beta = Levered Beta / (1 + ((1 – Tax Rate) x (Debt/Equity)))

                        = 1.20/ (1+ ((1-0.40) x 0.6667)

                        = 1.20/ 1.40

                        = 0.8571

Levered beta at new D/E (0.50/0.50=1)

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

                        =0.8571 x(1+(1-0.40) x1)

                        = 1.3714

New cost of equity:

Re = Rf + MRP x beta

      = 0.06 +0.05 x1.3714

      =12.86%

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