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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
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HAMADA EQUATION Situational Software Co. (SSC) is trying to establish its optimal capital structure. Its current capital structure consists of 25% debt and 75% equity; however, the CEO believes that the firm should use more debt. The risk-free rate, rRF, is 4%; the market risk premium, RPm, is 5%; and the firm's tax rate is 40%. Currently, SSC's cost of equity is 12%, which is determined by the CAPM. What would be SSC's estimated cost of equity if it changed its capital structure to 40% debt and 60% equity?

Summary Introduction

To calculate: Cost of equity if the firm changed its capital structure to 40% debt and 60% equity.

Introduction:

Cost of equity:

Cost of equity is the return that an investor expects from a firm on the money invested by the investors.

Explanation

Calculation of cost of equity

Given,

Risk-free rate of return is 4%.

The market risk premium is 5%.

Beta is 1.87 (Working notes).

The formula to calculate the cost of equity

Costofequity=[Riskfreerateofreturn+(Marketriskpremium×Beta)]

Substitute 4% for risk-free rate of return, 5% for market risk premium and 1.87 for the beta.

Costofequity=4%+(5%×1.87)=4%+9.35%=13.35%

Working notes:

Calculation of current levered beta

The current capital structure consists of 25% debt and 75% equity.

Beta=CostofequityRiskfreerateofreturnMarketriskpremium=12%4%5%=8%5%=1

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