Question

Max Inc. currently has a debt ratio of 50%. The total market value of its equity is $10 million, and the market value of its debt is also $10 million. Max Inc. has decided that lower leverage would be optimal, so it is considering restructuring its capital structure by issuing $3 million in equity and using the proceeds to retire debt (repurchase their outstanding bonds). Max Inc. currently has an equity beta of 1.2 and its cost of debt at 4%. The market risk premium is 10% and the risk free rate is 4%. Max Inc. pays no taxes and has no bankruptcy risk. Max Inc.'s cost of debt will not change as a result of the restructuring (no change in bankruptcy risk, so no change in default premiums)>

a. What is the current WACC for Mac Inc.?

b. Based on M&M theory, what will be the new WACC for Mac Inc. after the financial restructuring?

c. What will the new equity beta of the firm be?

d, What will the new cost of equity for the firm after restructuring?

Answer 1

Data Provided in the Question is as follows

Debt to Equity Ratio = 1:1

Market Value of Equity = $10M   - (1)

Market Value of Debt = $10M     - (2)

Firm Value = (1) + (2) = $20M

New Equity raised to repay Debt = $3M

Now,

Equity = $13M

Debt = $7M

Equity Beta = 1.2

K_d (Cost of Debt) = 4% ; K_e (Cost of Equity) = ?

Market Risk Premium = 10% (Market Return - Risk Free Return)

R_f (Risk Free Return) = 4%

a) Calculation of Current WACC

WACC = (K_d * W_d) * (K_e * W_e) {W stands for weights}

Now as per CAPM

K_e = R_f + (b_e * Market Premium)

K_e = 4% + (1.2* 10%)

K_e = 10%

WACC = (16% * 0.5) + (4% * 0.5) = 10%

b) New WACC of Firm

M&M Theory made 2 propositions

• Proposition I: This proposition says that the capital structure is irrelevant to the value of a firm. The value of two identical firms would remain the same, and value would not be affected by choice of finance adopted to finance the assets. The value of a firm is dependent on the expected future earnings. It is when there are no taxes

• Proposition II: This proposition says that the financial leverage boosts the value of a firm and reduces WACC. It is when tax information is available

In this question since no tax is paid by company therefore Proposition I will be applicable. Which shows Value of firm will remain same. Consequently it's WACC will also remain same

Therefore New WACC= Old WACC = 10%

d) New Ke of Firm

WACC = (K_d * W_d) * (K_e * W_e)

Since WACC will remain same after restructuring therefore

10% = {4% * (7/20) } + {K_e * (13/20) }

Solving the equation we get K_e = 13.23%

c) New Equity Beta of Firm

As per CAPM

K_e = R_f + (b_e * Market Premium)

In the following case

13.23% = 4% + b_e * (10%)

Solving the equation gives b_e = 0.923