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 7.5% yield to maturity. The risk-free rate (rRF) is 5.5%, and the market risk premium (rM – rRF) is 6.5%. Using the CAPM, MME estimates that its cost of equity is currently 10.3%. The company has a 40% tax rate.

a. What is MME's current WACC? Do not round intermediate calculations. Round your answer to two decimal places.

________ %

b. What is the current beta on MME's common stock? Do not round intermediate calculations. Round your answer to four decimal places.

__________

c. What would MME's beta be if the company had no debt in its capital structure? (That is, what is MME's unlevered beta, bU?) Do not round intermediate calculations. Round your answer to four decimal places. 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 8%. 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? Do not round intermediate calculations. Round your answer to two decimal places.

_________ %

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

f. Based on your answer to Part e, would you advise MME to adopt the proposed change in capital structure?

a.) The firm should proceed with the recapitalization

b.) The firm should not proceed with the recapitlization

Answer 1

a) WACC= Cost of debt * weight of debt * ( 1- tax rate) + cost of equity * Weight of equity

Wacc = 7.5% *0.35 *(1 - 0.40) + 10.3* 0.65

WACC= 1.575% + 6.695%

WACC = 8.27%

b)

Cost of equity using capm = Rf + Beta ( Rm - Rf)

10.3% = 5.5% + beta * 6.5%

Beta * 0.065 = 0.103 - 0.055

Beta = 0.048 / 0.065

Beta = 0.738

C) Calculation of the unleavered beta:-

Unlevered beta = Levered equity beta / (1 +[ (1-tax rate) * (debt / equity)])

Unlerevered beta = 0.738 / ( 1 + ( 1 - 0.40) * ( 0.35 / 0.65))

= 0.738 / ( 1+ 0.3231)

un levered beta =0.5578

D)Here capital structure is restructure ie. 45% debt & 55% equity

So, Beta is relevereging

New levered beta = unlevered beta * ( 1+ (1-tax) * (debt/Equity))

= 0.5578 * ( 1+ 0.60 *( 0.45/0.55))

= 0.8316

new Cost of equity after restructure = 5.5% + 0.8316 * 6.5%

New cost of equity = 10.9054%

e)

Cost of debt increses to 8%

WACC= Cost of debt * weight of debt * ( 1- tax rate) + cost of equity * Weight of equity

Wacc = 8% *0.45 *(1 - 0.40) + 10.9054* 0.55

WACC= 2.16% + 5.99797%

WACC = 8.15797%

WACC = 8.16%

F) the firm should proceed with recapitilization because of weighted cost of capital decreses from 8.27% to 8.16%