Question

1. 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. The risk-free rate is 6% and the market risk premium is 5%. Currently the company’s cost of equity 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?

Answer 1

Estimated cost of equity=(12%-6%)/5%*(1+(1-40%)*50%/50%)/(1+(1-40%)*20%/80%)*5%+6%
=14.348%