the company has an equity market capitalization of 400 million and 100 million i
ID: 2729418 • Letter: T
Question
the company has an equity market capitalization of 400 million and 100 million in outstanding debt, with a yield to maturity of %. the company's equity beta is 1.2. the risk-free rate ia 2.5% and the market risk premium is 4.5%
A) assume the company's debt has a beta of zero. Estimate the company's unlevered beta. Use the unlevered beta and the CAPM to estimate the unlevered cost of capital.
B) Estimate the company's equity cost of capital using the CAPM. then assume its debt cost of capital equals its YTM and using these results, estimate the company's unlevered cost of capital.
Explanation / Answer
Part A
Debt equity ratio = debt/ equity
= 100 million/ 400 million
= 0.25
Unlevered Beta (Bu) = BL / (1+ D/E x (1-t))
= 1.20 / (1+ 0.25 x (1-0) )
= 1.20 / 1.25
= 0.96
Unlevered Cost of capital using CAPM = Rf+ Bu x MRP
= 0.025 + 0.96 x 0.045
= 6.82%
Part B
Equity cost of capital = Rf + BL x MRP
= 0.025 + 1.20 x 0.045
= 7.90%
RL = Ru + D/ E x( Ru – Rd)
0.0790 = Ru + 0.25 x (Ru-0.03)
0.0790 = Ru + 0.25 Ru + 0.0075
Ru = 0.0715/ 1.25
= 5.72%
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