# Estimated cost of equity

A software company is trying to estimate its optimal capital structure. Right now, it 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 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 the company's estimated cost of equity if it were to change its capital structure to 50 percent debt and 50 percent equity?

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#### Solution Preview

Facts given: rs=12%; D/S =0.25; rRF=6%; RPM=5%; T =40%.

Step 1:Find the firm's current levered beta using the CAPM:

rs =rRF+RPM x beta

12%=6% +5% x ...

#### Solution Summary

The solution explains how to calculate the cost of equity given a change in capital structure.