Question

6. Assume you have just been hired as a business manager of Bernie’s Burgers, a regional hamburger restaurant chain. The company’s EBIT was $150 million last year and is not expected to grow. The firm is currently financed with all equity and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firm’s owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm’s investment banker the following estimated costs of debt for the firm at different capital structures:

                                                   % Financed With Debt            r_d            

                                                               0%                              ---      

                                                              25                                 8.0%     

                                                              33                                 8.5      

                                                              45                                10.0      

                                                              55                               12.0      

If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. Bernie’s Burgers is in the 28 percent state-plus-federal corporate tax bracket, its beta is 1.27, the risk-free rate is 6 percent, and the expected return on the market is 11 percent.

1. Calculate the leveraged beta for each capital structure.

        b.Calculate the cost of capital for each capital structure.

Answer 1