Question

Quantitative Problem: Currently, Meyers Manufacturing Enterprises (MME) has a capital structure consisting of 35% debt and 65% equity. MME's debt currently has a 7.2% yield to maturity. The risk-free rate (r_RF) is 5.2%, and the market risk premium (r_M – r_RF) is 6.2%. Using the CAPM, MME estimates that its cost of equity is currently 11.2%. The company has a 40% tax rate.

a. What would MME's beta be if the company had no debt in its capital structure? (That is, what is MME's unlevered beta, b_U?) Round your answer to 4 decimal places. Do not round intermediate calculations.

MME's financial staff is considering changing its capital structure to 45% debt and 55% equity. If the company went ahead with the proposed change, the yield to maturity on the company's bonds would rise to 7.7%. The proposed change will have no effect on the company's tax rate.

d. What would be the company's new cost of equity if it adopted the proposed change in capital structure? Round your answer to 2 decimal places. Do not round intermediate calculations.
%

e. What would be the company's new WACC if it adopted the proposed change in capital structure? Round your answer to 2 decimal places. Do not round intermediate calculations.
%

Answer 1

Answer:-

Hope its helps you...

-a:-

Current WACC = Cost of Equity(Ke) * ( % of Equity) + Cost of Debt (Kd) * (% of Debt)

= 11.20 ( 65%) + 7.20 *0.60*(35%).. = 8.79

Note Yield to Maturity = 7.20 is generally before tax.

so we make it after tax by multipying with 1 - Tc = 1 - 0.40 = 0.60

b::-

beta can be derived from CAPM formula

Ke = Rf + Beta( Rm - Rf) = 11.20 given

5.2 + Beta (6.2) = 11.20

Beta = (11.2 - 5.2) / 6.2 = 0.9677

c:-

Beta (UL) = Beta (L)/ [ 1 + {(1 - tax rate)*(D/E)}]

1 - 0.40 = 0.60 ...........It will be multiplied with Debt equity ratio .....35/65

{(1 - tax rate)*(D/E)} = 0.60 * 35/65 = 0.3230769

[ 1 + {(1 - tax rate)*(D/E)}] = 1 + 0.3230769 = 1.3230769

Refer to question - b above......... we calculated Levered Beta = B(L) = 0.9677

B(UL) = Unlevered Beta = 0.9677/ 1.3230769 = 0.7341

d:"-

Firstly we have to estimate Beta at a leverage level of 45/55

B(L) = B(UL) * [ 1 + {(1 - tax rate)*(D/E)}]

= 0.7341 * [ 1 + (0.60)*45/55] = 1.0944763636

Cost of Equity = Rf + Beta ( Rm - Rf) = 5.2 + 1.0944763636 ( 6.20) = 11.98

e:-

WACC = 11.98(55%) + 7.20*0.60*(45%) = 8.53

f:--

Refer to question - a we had calculated WACC = 8.79%, now under revised D/E ratio you can observe that WACC marginally declined to 8.53%. So MME is advised to adopt the proposed change in light of decrease in the WACC.