Question

Beckman Engineering and Associates (BEA) is considering a change in its capital structure. BEA currently has $20 million in debt carrying a rate of 7%, and its stock price is $40 per share with 2 million shares outstanding. BEA is a zero-growth firm and pays out all of its earnings as dividends. The firm's EBIT is $14 million, and it faces a 25% federal-plus-state tax rate. The market risk premium is 6%, and the risk-free rate is 7%. BEA is considering increasing its debt level to a capital structure with 45% debt, based on market values, and repurchasing shares with the extra money that it borrows. BEA will have to retire the old debt in order to issue new debt, and the rate on the new debt will be 13%. BEA has a beta of 1.0.

1. What is BEA's unlevered beta? Use market value D/S (which is the same as w_d/w_s) when unlevering. Do not round intermediate calculations. Round your answer to two decimal places.

2. What are BEA's new beta and cost of equity if it has 45% debt? Do not round intermediate calculations. Round your answers to two decimal places.

   Beta:

   Cost of equity:   %

3. What is BEA's WACC with 45% debt? Do not round intermediate calculations. Round your answer to two decimal places.

     %

   What is the total value of the firm with 45% debt? Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.234 million should be entered as 1.234, not 1,234,000. Round your answer to three decimal places.

   $   million

Answer 1

- Value of Debt = $20 million

- Value of Equity = $40*2 million shares

= $80

BEA beta = 1.0

a). Calculating unlevered Beta:-

Unlevered Beta = Equity Beta/[1+(1-Tax rate)*Debt/Equity]

= 1.0/[1+(1-0.25)*20/80]

Unlevered Beta = 0.842105

So, unlevered bets is 0.84

b). Calculating Equity beta with new debt of 45%:-

Levered Beta = Unlevered Beta*[1+(1-Tax rate)*Debt/Equity]

Levered Beta = 0.842105*[1+(1-0.25)*0.45/0.55]

Levered Beta = 1.358851

So, Levered Beta is 1.36

As per CAPM,

Expected Return = Rf + beta*(Rmp)

Rf = Risk free Return = 7%

Rmp = Market Risk Premium = 6%

Beta = 1.358851

Expected Return = 7% + 1.358851(6%)

= 15.153107%

So, Cost of Equity is 15.15%

c). Calculating BEA's WACC with 45% debt amount:-

Before-tax Cost of Debt of new debt is 13%

WACC= (Weight of Debt)(Before-tax Cost of Debt)(1-Tax Rate) + (Weight of Equity)(Cost of Equity)

WACC = (0.45)(13%)(1-0.25) + (0.55)(15.153107%)

WACC = 4.3875% + 8.334209%

WACC = 12.721709%

So, WACC = 12.72%

d). Total Value of Firm with 45% Debt = EBIT(1-Tax Rate)/WACC

Total Value of Firm = $14 million(1- 0.25)/12.721709%

Total Value of Firm = $82.536 million