Question

Carpetto Technologies Inc. has a market capitalisation of $50 million and $50 million in outstanding debt. Its corporate tax rate is 31%.

1.The beta of Carpetto Technologies Inc. is 1.7, the risk-free rate is 8.5%, and the return on market is 13.5%, what will be Carpetto’s cost of common equity using the Capital Asset Pricing Model (CAPM) approach?

2.Suppose Carpetto’s debt of cost of capital is 10.5%. What is Carpetto’s after tax debt of cost of capital?                                                                     3.What is unlevered cost of capital for Carpetto?

4.What is the weighted average cost of capital (WACC) for Carpetto?  

5.Why its WACC (in part (iv)) is lower than the unlevered cost of capital (in part (3))?

Answer 1

All parts have photos attached to them

Part 1)

With all the above given data, we use it into the formula & obtain result.

By applying formula & doing calculations, the result we obtain is,

Cost of equity = 17% Using CAPM Method.

Part 2)

As you might know, interest is an tax deductible item. So, the actual cost of debt is incurred is always than the cost of debt specified.

By applying formula & doing calculations, the result we obtain is,

After tax cost of debt is $3,622,500.

Part 3)

In order to calculate unlevered cost of capital, we first need to obtain unlevered beta.

In unlevered beta calculation, there is one component named D/E, where D = Amount of debt & E = Amount of Equity.

As both the amounts are equal i.e. $50mn, the ratio of D/E = 1.

After calculation, unelevered beta = 1.

Unlevered cost of capital = 13.5%.

Part 4)

Formula for WACC is

where,

We = wieght of equity = 50%

Wd = Weight of debt = 50%  

We = Equity Amount / Equity + Debt Amount = 50/100 = 50%

Wd = Debt Amount / Equity + Debt Amount = 50/100 = 50%.

After calculation,

WACC = 12.1%