Q5. Cartwright Communications is considering making a change to its capital stru
ID: 2749814 • Letter: Q
Question
Q5. 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, rM rRF, is 5%. Currently the company's cost of equity, which is based on the CAPM, is 12% and its tax rate is 40%. What would be Cartwright's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?
Explanation / Answer
cost of equity = risk free rate + beta * market risk premium
12 = 6+beta*5
beta = 1.2
unlevered beta = Levered Beta / (1 + ((1 – Tax Rate) x (Debt/Equity)))
= 1.2/(1+((1-0.4)*(.25))) = 1.043478
Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))
= 1.043478*(1+((1-.4))*(.5/.5))) = 1.6695
cost of equity = risk free rate + beta * market risk premium
cost of equity = 6+1.6695*5
cost of equity = 14.3475
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