Question

Cartwright Communications is considering making a change to its capital structure to reduce its cost of capital and increase firm value. Right now, Cartwright has a capital structure that consists of 20% debt and 80% equity, based on market values. (Its D/S ratio is 0.25.) The risk-free rate is 6% and the market risk premium, r M − r RF, is 5%. Currently the company's cost of equity, which is based on the CAPM, is 12% and its tax rate is 25%. What would be Cartwright's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?

a. 13.00% b. 14.84% c. 15.58% d. 13.65% e. 16.00%

Answer 1

Given about Cartwright Communications,

Current D/E ratio = 0.25

risk-free rate Rf = 6%

market risk premium, MRP = 5%

based on the CAPM, is 12%

So, based on CAPM Ke = Rf + Beta*MRP

So, Beta of the company = (12 - 6)/5 = 1.2

tax rate t = 25%

This beta calculated is Levered beta.

So, unlevered beta = Levered beta/(1 + (1-t)*D/E) = 1.2/(1 + (1-0.25)*.25) = 1.01

Based on change in Capital structure, New D/E ratio = 50/50 = 1

So, new levered beta of the firm = 1.01*(1 + (1-0.25)*1) = 1.77

Based on this beta and CAPM model, new Cartwright's estimated cost of equity = 6 + 1.77*5 = 14.84%

Thus option B is correct.