Fundamentals of Financial Manageme...
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Fundamentals of Financial Manageme...
HAMADA EQUATION Cyclone Software Co. 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 5%; the market risk premium, RPM, is 6%; and the firm’s tax rate is 40%. Currently, Cyclone’s 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 50% debt and 50% equity?
To identify: The cost of equity at the 50% of debt and 50% of equity.
Return on Equity:
The return which is generated on the equity that is invested by the stockholders is known as return on equity.
Compute the beta.
Given,
The risk free rate is 5%.
The risk premium is 6%.
The cost of equity is 14%.
Formula to calculate beta derives from the formula of cost of equity,
Substitute 5% for risk free rate, 6% for risk premium and 14% for cost of equity.
The beta is 1.273.
Compute the unlevered beta.
The tax rate is 40% or 0.40. (Given)
The debt is 25%. (Given)
The equity is 75%. (Given)
The levered beta is 1.273. (Calculated)
Formula to calculate the unleveraged debt,
Substitute 1.273 for levered beta, 0.40 for tax rate, 25% for debt and 75% for equity.
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