Question

George, the automotive manufacturer, had a beta of 1.05 in 1995. It had $13 billion in debt outstanding in that year and 355 million shares trading at $50 per share. The marginal tax was 36%

1. Estimate the unlevered beta of the firm

2. Suppose the firm paid out a special dividend of $5 billion, what is the new beta for George after the special dividend? Hint: dividend reduces equity

3. How does the dividend payout affect the cost of equity and cost of debt for George?

Answer 1

Formula for unlevered Beta

Unlevered Beta (βA) =	Equity Beta (βE)
	1 + (1 − t) × D/E

Equity Beta (β_E) = 1.05

tax rate (t) = 36% or 0.36

debt = $13 billion

equity = 355 million x $50 = 17.75 billion

Unlevered Beta (β_A) = 1.05/ 1 + (1-0.36) x (13 / 17.75)

= 1.05 / 1 + (0.64) x (0.73239)

= 1.05 / 1 + 0.46873

= 0.71490

2. firm paid out a special dividend of $5 billion

1.05/ 1 + (1-0.36) x (13 / 12.75)

1.05/ 1 + (1-0.36) x 1.01960

1.05/ 1 + 0.65254

0.635385

3.Dividend payout affect the cost of equity and cost of debt

There are two ways a company can raise capital: debt or equity. Debt is cheaper, but the company must pay it back. Equity does not need to be repaid, but it generally costs more than debt capital due to the tax advantages of interest payments.

if the firm decides to pay dividend the over all earnings of firm reduces and hence the reatined earnings reduce which saves taxes or reduces the absolutevalue of tax .

As we know the cost of raising debt in a firm is the interest payments paid on the sum raised , while computing the interest payments in financial statements the value of payment reduces if the dividend payout is high .