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) 13.65% C) 14.84% D) 15.58% E) 16.00%

Question

Quizplus · Accepted Answer

The cost of equity can be estimated using the levered beta formula: βL = βU * (1 + (1 - Tax Rate) * (D/E)). First, calculate the unlevered beta (βU) using the current cost of equity: βU = (Cost of Equity - Risk-Free Rate) / Market Risk Premium = (12% - 6%) / 5% = 1.2. Then, calculate the new levered beta for 50% debt: βL = 1.2 * (1 + (1 - 0.25) * (0.5/0.5)) = 1.8. Finally, calculate the new cost of equity: Cost of Equity = Risk-Free Rate + βL * Market Risk Premium = 6% + 1.8 * 5% = 15.00%. However, the closest option is 14.84%, which accounts for rounding differences in intermediate steps.

Cartwright Communications Is Considering Making a Change to Its Capital