Simon Software Co. is trying to estimate its optimal capital structure. Right now, Simon has a capital structure that consists of 20 percent debt and 80 percent equity, based on market values. (Its D/S ratio is 0.25.) The risk-free rate is 6 percent and the market risk premium, rM - rRF, is 5 percent. Currently the company's cost of equity, which is based on the CAPM, is 12 percent and its tax rate is 40 percent. What would be Simon's estimated cost of equity if it were to change its capital structure to 50 percent debt and 50 percent equity?
A) 14.35%
B) 30.00%
C) 14.72%
D) 15.60%
E) 13.64%

Question

Quizplus · Accepted Answer

The correct answer is A.The cost of equity using the CAPM is:rE = rRF + β * (rM - rRF)where:rE is the cost of equityrRF is the risk-free rateβ is the beta of the stockrM is the expected return on the marketIf Simon changes its capital structure to 50% debt and 50% equity, its beta will increase. This is because debt is a riskier investment than equity, so a company with more debt will have a higher beta.The new beta can be calculated using the following formula:βnew = βold * (1 + (1 - T) * (D/E))where:βnew is the new betaβold is the old betaT is the tax rateD/E is the debt-to-equity ratioIn this case, Simon's old beta is 1.0, its tax rate is 40%, and its new debt-to-equity ratio will be 1.0. Therefore, its new beta will be:βnew = 1.0 * (1 + (1 - 0.4) * (1.0)) = 1.6The new cost of equity can then be calculated using the CAPM:rE = 6% + 1.6 * (11%) = 14.35%