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 8%, 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 4%, and the risk-free rate is 6%. BEA is considering increasing its debt level to a capital structure with 50% 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 10%. BEA has a beta of 1.1.

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

B. What are BEA's new beta and cost of equity if it has 50% debt? Do not round intermediate calculations. Round your answers to two decimal places. Beta: 1.30 Cost of equity: %

C. What is BEA's WACC with 50% debt? Do not round intermediate calculations. Round your answer to two decimal places. %

D. What is the total value of the firm with 50% 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.

Answer 1

- Value of Debt = $20 million

- Value of Equity = $40*2 million shares

= $80

BEA beta = 1.1

a). Calculating unlevered Beta:-

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

= 1.1/[1+(1-0.25)*20/80]

= 0.926316

So, unlevered bets is 0.92

b). Calculating Equity beta with new debt of 50%:-

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

= 0.926316*[1+(1-0.25)*0.50/0.50]

= 1.621053

So, Levered Beta is 1.62

As per CAPM,

Expected Return = Rf + b(Rmp)

Rf = Risk free Return = 6%

Rmp = Market Risk Premium = 4%

Beta = 1.621053

Expected Return = 6% + 1.621053(4%)

= 12.484212%

So, Cost of Equity is 12.48%

c). Calculating BEA's WACC with 50% debt amount:-

Before-tax Cost of Debt of new debt is 10%

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

WACC = (0.50)(10%)(1-0.25) + (0.50)(12.484212%)

WACC = 3.75% + 6.2421%

WACC = 9.9921%

So, WACC is 9.99%

d). Total Value of Firm with 50% Debt = EBIT(1-Tax arte)/WACC

= $14 million(1- 0.25)/9.9921%

= $105.083 millions