Situational Software Co. (SSC) is trying to establish its optimal capital structure. Its current capital structure consists of 35% debt and 65% equity; however, the CEO believes that the firm should use more debt. The risk-free rate, rRF, is 3%; the market risk premium, RPM, is 7%; and the firm's tax rate is 25%. Currently, SSC's cost of equity is 16%, which is determined by the CAPM. What would be SSC's estimated cost of equity if it changed its capital structure to 50% debt and 50% equity? Do not round intermediate calculations. Round your answer to two decimal places.

19.22%

Explanation:

Let the Beta be x

Cost of equity (CAPM) = risk free rate + Beta (Market risk premium)

16% = 3% + x (7%)

13% = 7%x

x = Beta = 1.86

Debt Equity ratio

= Debt : Equity

=35% : 65%

= 0.54

Beta levered = Beta unlevered [1 + (1 - tax rate) Debt equity ratio]

1.86 = Beta Unlevered [1 + (1 - 25%) * 0.54) ]

Beta unlevered = 1.3238

Calculation of Beta at new required capital structure where debt = 50% and equity = 50%

Debt Equity ratio

= Debt : Equity

=50% : 50%

= 1

Beta levered = Beta unlevered (1 + (1 - tax rate) Debt equity ratio)

Beta levered = 1.3238 (1 + (1 - 0.25) * 1)

Beta levered = 2.3166

CAPM Cost of equity = risk free rate + Beta (Market risk premium)

Cost of equity (K e) = 3% + 2.3166 (7%)

Cost of equity (K e) = 19.22%

Thus, the Cost of equity in case of changed capital structure is 19.22%.