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 40%.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) 13.64% C) 14.35% D) 14.72% E) 15.60%

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 = βL / (1 + (1 - Tax Rate) * (D/E)). Then, calculate the new levered beta for the 50% debt structure and use it to find the new cost of equity with CAPM: Cost of Equity = Risk-free rate + Levered Beta * Market Risk Premium.

Cartwright Communications Is Considering Making a Change to Its Capital