Situational Software Co. (SSC) is trying to establish its optimalcapital structure. Its current capital structure consists of 25% debt and 75% equity;however, the CEO believes that the firm should use more debt. The risk-free rate, rRF,is 4%; the market risk premium, RPM, is 5%; and the firm’s tax rate is 40%. Currently,SSC’s cost of equity is 12%, which is determined by the CAPM. What would beSSC’s estimated cost of equity if it changed its capital structure to 40% debt and60% equity?
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Situational Software Co. (SSC) is trying to establish its optimal
capital structure. Its current capital structure consists of 25% debt and 75% equity;
however, the CEO believes that the firm should use more debt. The risk-free rate, rRF,
is 4%; the market risk premium, RPM, is 5%; and the firm’s tax rate is 40%. Currently,
SSC’s
SSC’s estimated cost of equity if it changed its capital structure to 40% debt and
60% equity?
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