Question

1. You are trying to estimate Cost of Capital for MGM Enterprises in question 1, and the EV change in question 2, the company that operates in two businesses, with the following breakdown:

The company is trading at its fair value, has no cash and $ 1 billion ($1000 in millions) in debt outstanding. The marginal tax rate is 30%. The risk free rate is 1.5%. ERP, 5.5%. Default risk is 2%

1. Estimate WACC. Hint: first calculate the weighted unleveled beta, then average levered beta for the company.

1. 	MOVIES	CASINOS
   ENTERPRISE VALUE IN MIILIONS	$1500	$1500
   UNLEVERED BETA	0.9	0.6

2. Now assume that MGM plans to sell its Casinos for its fair value, hold half the proceeds as a cash balance and use the remaining half to pay a special dividend. Estimate the value change in the company Hint: First, Estimate the levered beta after the transaction, calculate WACC and then the change in Enterprise Value. Default risk goes up to 3%. The marginal tax rate is 30%. The risk free rate is 1.5%. ERP, 5.5%.

What is the Enterprise Value change due to the restructuring?

Answer 1

Enterprise Value (EV) of the firm is the value of the firm which includes both equity and debt.

In our problem EV of both businesses is given and firm has only 2 businesses so by adding the EV of these 2 businesses we can get EV of firm.

So EV of MGM Enterprises is EV of Movies business + EV of Casino business

So EV = $ 3000 Mn

Break up of Debt and Equity

Debt = $1000 Mn (given)

Equity = $ 2000 Mn (3000-1000)

Debt-to-Equity Ratio

= Debt / Equity

= 1000 / 2000

= 0.5      

To calculate the weighted unleveled beta

Weight of each business unit is 50% (1500/3000) or (EV of business/EV of Firm)

So Weighted Unleveled beta = Unleveled beta of movies business * weight of movies business + Unleveled beta of casino business * weight of casino business

= 0.9*0.5 + 0.6*0.5

= 0.45 + 0.3

= 0.75

To calculate levered beta using this formula

Levered Beta = Unlevered Beta * (1+D*(1-T)/E) where T is the tax rate.

= 0.75*(1+1000(1-0.3)/2000)

= 0.75 * (1+0.35)

= 1.0125

To estimate Cost of Capital using Capital asset pricing model (CAPM)

Cost of Capital = Risk free + Beta* Risk premium

= 1.5% + 1.0125*5.5%

= 0.015 + 0.0556875

= 0.0706875 or 7.068%

Cost of Equity for MGM Enterprises is 7.068%

If MGM Enterprises sells its Casinos for its fair value which is $1500 mn then they receive this amount of $ 1500 Mn. out of this 50% i.e. $ 750 mn is paid to bank and the debt is now reduced to $ 250 mn (1000-750)

Remaining 50% i.e. $ 750 Mn is paid as dividend so no cash with company

So new Debt and Equity will be

Debt = $ 250 Mn

Equity = $ 1250 Mn (1500 -250)

New Debt-to-Equity Ratio will be

= Debt / Equity

= 250 / 1250

= 0.2

Now the

New Levered Beta = Unlevered Beta * (1+D*(1-T)/E) where T is the tax rate.

= 0.9 * (1+250*(1-0.3)/1250)

= 0.9 * 1.14

= 1.026

So levered beta after the transaction is 1.026

Using CAPM the cost of Capital

Cost of Capital = Risk free + Beta* Risk premium

= 1.5% +1.026*5.5%

= 0.015+ 0.05643

= 0.07143 or 7.143%

The cost of debt for a company is then the sum of the riskfree rate and the default spread:

Pre-tax cost of debt = Risk free rate + Default spread

Default risk or spread given to us 3%

So Pre-tax cost of debt = 1.5% + 3%

= 4.5%

WACC = Cost of Equity * E/(E+D) + cost of debt *D/(E+D)

=0.0706875 * 1250/1500 + 0.045* 250/1500

= 0.0706875*0.83 + 0.045*0.17

= 0.05867 + 0.00765

= 0.06632 or 6.632%

WACC = 6.632%

The calculation for EV is

Enterprise value = common equity at market value + debt at market value + minority interest at market value + preferred equity at market value + unfunded pension liabilities and other debt-deemed provisions – value of associate companies – cash and cash equivalents.

Based on this we only have debt and equity given to us.

Now as MGM enterprise is trading at Fair value so the EV of company will be EV of its business. After the transaction the EV of company is only of its movies business which is $ 1500 mn

So the EV has reduced to half i.e. $ 1500 Mn post restructuring.