8. Problem 13.08 Problem 13-8 Hamada equation Cyclone Software Co. is trying to

Question

8. Problem 13.08 Problem 13-8 Hamada equation Cyclone Software Co. is trying to establish its optimal capital structure. Its current capital structure consists of 20% debt and 80% equity; however, the CEO believes the firm should use more debt. The risk-free rate rRF s 5%; the market risk premium RPM: is 5%; and the firm's tax rate is 409 Currently, Cyclones cost of equity is 14% which is determined by the CAPM. what would be cyclone's estimated cost of equity if it changed its capital structure to S09 debt and S096 equity? Round your answer to two decimal places

Explanation / Answer

Current Cost of Equity = 14%
tax rate = 40%
Weight of Debt, D = 20%
Weight of Equity, E = 80%
Risk-free rate, rRF = 5%
Market risk premium, RPM = 5%

Cost of Equity = rRF + Levered beta * RPM
14% = 5% + Levered beta * 5%
9% = Levered beta * 5%
Levered beta = 1.80

Unlevered Beta = Levered beta / [1 + (1-tax)*(D/E)]
Unlevered Beta = 1.80 / [1 + (1-0.40)*(0.20/0.80)]
Unlevered Beta = 1.80 / 1.15
Unlevered Beta = 1.57

If capital structure changed to 50% debt and 50% equity:

Unlevered Beta = 1.57

Levered Beta = Unlevered beta * [1 + (1-tax)*(D/E)]
Levered Beta = 1.57 * [1 + (1-0.40)*(0.50/0.50)]
Levered Beta = 1.57 * 1.60
Levered Beta = 2.512

Cost of Equity = rRF + Levered beta * RPM
Cost of Equity = 5% + 2.512 * 5%
Cost of Equity = 17.56%

So, estimated cost of equity is 17.56%

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