Question

ABC Corp. debt is P15 million and has an equity of P5 million. Its historical levered equity beta has been 2. If the firm were to increase its leverage from P15 million to P18 million and use the cash to repurchase shares, what would you expect its levered equity beta to be

Answer 1

Answer-

Asset beta = Equity beta / [ 1+ (1 - tax rate ) x Debt / Equity ]

let the tax rate = 40 % = 0.40

Asset beta = 2 / [ 1 + ( 1 - 0.4) x (15 / 5) ]

Asset beta = 2 / [ 1 + 0.6 x 3 ]

Asset beta = 2 / 2.8

Asset beta = 0.714

Now after repurchase of shares

Debt increases from 15 to 18 and equity decreases from 5 to 2.

Equity beta = Asset beta x [ 1+ (1 - tax rate ) x Debt / Equity ]

Equity beta = 0.714 x [ 1 + ( 1 - 0.4 ) x 18/2 ]

Equity beta = 0.714 x [ 1 + (0.6 x 9) ]

Equity beta = 0.714 x 6.4

Equity beta = 4.57

therefore equity beta increases from 2 to 4.57.