Hamada equation Cyclone Software Co. is trying to establish its optimal capital

Question

Hamada equation

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 13%, 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

Initial D/E Ratio=40/60 Assume geared beta at this D/E ratio is ba Risk free rate =Rf=6% Market Risk Premium =5% Cost of Equity =13% So By CAPM 13%=6%+5%*ba ba=1.40 Tax Rate =T=40% Assume ungeared beta -bU bU=bD*D/(D(1-T)+E)+ba*E/(D(1-T)+E) As beta of debt =bD=0, bU=ba*E/(D+E) =1.4*0.60/(0.6+0.24)=1 So ungeared beta =1 When D/E is 50/50, we need to regear Equity Beta Assume equity beta at this D/E level is bG bG=bU+(bU-bD)(1-t)*D/E As bD= o, Tax rate =40% bG=1+1*0.60*50/50 =1.6 So Beta of equity at this level is 1.6 Risk free rate =Rf=6% Market Risk Premium =5% Cost of Equity =6%+5%*1.6 So Cost of Equity at this level =14% So At D/E level of 50:50, the cost of Equity =14%

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