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%
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.
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