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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

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?

Summary Introduction

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.

Explanation

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,

CostofEquity=RiskFreeRate+RiskPremium×BetaBeta=CostofEquityRiskFreeRate+RiskPremium

Substitute 5% for risk free rate, 6% for risk premium and 14% for cost of equity.

Beta=14%5%+6%=14%11%=1.273

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,

UnleveredBeta=LeveredBeta1+((1TaxRate)×DebtEquity)

Substitute 1.273 for levered beta, 0.40 for tax rate, 25% for debt and 75% for equity.

UnleveredBeta=1.2731+((10.40)×25%75%)=1.2731+(0.60×0.33)=1

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