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 20% debt and 80% equity; however, the CEO believes the firm should use more debt. The risk-free rate, rRF, is 5%; 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

Given information

current structure Equity 80% and debt 20%

risk free rate 5%

risk premium 5%

tax rate 40%

current cost of equity- 13%

First we will calculate current beta

Cost of equity = risk free rate+ beta* risk premium

=13=5+beta*5 =beta =1.6

now we will calculate unlevered beta-

= levered beta/(1+(1- tax)(debt/equity))

=1.6/(1+(0.60*(.20/.80) =1.39

Now beta under new capital structure

=beta unlevered*(1+(1- tax)(debt/equity)

=1.39*(1+(0.60*(.50/.50) = 2.22

Thus new cost of equity = risk free rate+ new beta*risk premium

=5+2.22*5 = 16.10%

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