Question

Trident Co. is considering a change in its capital structure. Trident currently has $10 million in debt, and its stock price is $7.50 per share with 4 million shares outstanding. Trident is a zero growth rm and pays out all of its earnings as dividends. 5 MGMT 6170 It has no depreciation, no working capital investments, no capital expenditure, and no non-operating assets. Trident's annual EBIT is $5 million and it is constant forever. It faces a 35% tax rate. The market risk premium is 5%, and the risk-free rate is 3%. Trident is considering increasing its debt level to a capital structure with 45% debt, based on market values, and repurchasing shares with the extra money that it borrows. Trident will have to retire the old debt in order to issue new debt, and the yield on the new debt will be 8%. Currently Trident has a beta of 1.4.

(a) What is Trident's unlevered beta?

(b) What are Trident's new beta and cost of equity if it has 45% debt?

(c) What are Trident's WACC and total value of the rm with 45% debt?

Answer 1

- Value of Debt = $10 million

- Value of Equity = $7.50 per share*4 million shares

= $30 million

BEA beta = 1.4

a). Calculating unlevered Beta:-

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

= 1.4/[1+(1-0.35)*10/30]

= 1.150685

So, unlevered bets is 1.15

b). Calculating new beta with new debt of 45%:-

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

= 1.150685*[1+(1-0.35)*0.45/0.55]

= 1.762640

So, Levered Beta is 1.76

As per CAPM,

Rf = Risk free Return = 3%

Rmp = Market Risk Premium = 5%

Beta = 1.762640

Expected Return = 3% + 1.762640(5%)

= 11.81320%

So, Cost of Equity is 11.81%

c). Calculating BEA's WACC with 45% debt amount:-

Before-tax Cost of Debt of new debt is 8%

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

WACC = (0.45)(8%)(1-0.35) + (0.55)(11.81320%)

WACC = 2.34% + 6.4972606%

WACC = 8.8372606%

So, WACC is 8.84%

d). Total Value of Firm with 45% Debt = EBIT(1-Tax Rate)/WACC

= $$5 million(1- 0.35)/8.8372606%

= $ 36.776 million

So, Value of Firm is $ 36.776

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