Simon Software Co. is trying to estimate its optimal capital structure. Right now, Simon has a capital structure that consists of 20% debt and 80% equity, based on market values. (Its D/S ratio is 0.25.) The risk- free rate is 6% and the market risk premium, rM - rRF, is 5%. Currently the company's cost of equity, which is based on the CAPM, is 12% and its tax rate is 40%. What would be Simon's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?
A) 13.00%
B) 13.64%
C) 14.35%
D) 14.72%
E) 15.60%

Question

Quizplus · Accepted Answer

The cost of equity can be estimated using the CAPM and the Hamada equation to adjust for the change in leverage. The current beta can be derived from the CAPM: 12% = 6% + beta * 5%, giving beta = 1.2. Using the Hamada equation to adjust for the new capital structure: beta_levered = beta_unlevered * [1 + (1 - tax rate) * (D/E)], where D/E changes to 1. The new beta is 1.2 * [1 + (1 - 0.4) * 1] = 1.92. The new cost of equity is 6% + 1.92 * 5% = 14.6%, which is closest to 14.35%.