Question

A company has unleveraged beta of 1.7, risk free rate 7% and market risk premium for 5%. The applicable tax rate is 40%.
The company needs to finance its new project having three different scenarios of financing:

Scenario Debt ratio Interest rate (before tax) EPS
1 0% 0% $2.7
2 20% 12% $3.8
3 80% 17% $4.2

2) If the company is unleveraged, its Price per share is *

$11.75

$22.41

$17.42

None of the above

3) If the company has 20% Debt, its WACC is *

15.34%

0%

14.86%

None of the above

4) If the company has 20% Debt, its Price per share is *

$11.7

$10.2

$24.7

None of the above

5) If the company is 80% leveraged, its WACC is *

0%

15.34%

14.86%

None of the above

6) The optimal capital structure for the company *

Maximizes its price per share

Minimizes its WACC

All of the above

None of the above

7) At the optimal capital structure; WACC is _____ and price per share is _____. *

14.86%; 22.65%

14.86%; $24.65

14.86%; $22.65

None of the above.

8) The optimal capital structure for the company is: *

0% debt; 100% equity.

20% debt; 80% equity.

80% debt; 20% equity.

All of the above

Answer 1

2. Unlevered cost of equity ,ke

as per CAPM=

RFR+(Beta*Market risk premium)

ie. 7%+(1.7*5%)=

15.5%

Price/share= EPS/ke=

2.7/15.5%=

17.42

Answer:c--- 17.42

3. If the company is 20% leveraged,

We need to find , the levered beta , then cost of levered equity& then calculate WACC , for this 20% level of debt.

Levered beta=Unlevered beta*(1+((1-tax rate)*Debt/Equity)

ie. 1.7*(1+((1-40%)*20/80))=

1.955

Now, the levered cost of equity

as per CAPM,

RFR+(Beta*Market risk premium)

ie. 7%+(1.955*5%)=

16.78%

Now, the WACC=

(Wt.d*kd*(1-tax rate))+(Wt.e*ke)

(20%*12%*(1-40%))+(80%*16.78%)=

14.86%

Answer--c--- 14.86%

4. Price /share , if the co. has 20% debt:

EPS/Cost of equity

3.8/16.78%=

22.65

Answer: d---none of the above

5.If the company is 80% leveraged,

We need to find , the levered beta , then cost of levered equity& then calculate WACC , for this 80% level of debt.

Levered beta=Unlevered beta*(1+((1-tax rate)*Debt/Equity)

ie. 1.7*(1+((1-40%)*80/20))=

5.78

Now, the levered cost of equity

as per CAPM,

RFR+(Beta*Market risk premium)

ie. 7%+(5.78*5%)=

35.9%

Now, the WACC=

(Wt.d*kd*(1-tax rate))+(Wt.e*ke)

(80%*12%*(1-40%))+(20%*35.9%)=

12.94%

Answer: d---none of the above

6. Optimal capital structure maximises value & minimises WACC

Answer- c.---All of the above

7) At the optimal capital structure; WACC is 14.86% and price per share is   $ 22.65

Answer--c---- 14.86%; $22.65

as found in   3 & 4

8) The optimal capital structure for the company is:

Answer-b---20% debt; 80% equity.