Question

Kushlani Plc is considering changing its capital structure. Currently Kushlani has Rs. 10 million in debt at 8% and its stock price is Rs. 40 per share with 1 million shares outstanding. Kushlani is a zero growth firm and pays out all of its earnings as dividends. EBIT is Rs. 14.933 million and tax rate is 35%. Market risk premium is 4% and risk free rate is 6%. Kushlani is considering increasing its debt in capital structure to 30%, 40% or 50% at the interest rate of 8.25%, 8.5% and 9% respectively. Unlevered beta of Kushlani is 1.2.

1. What are Kushlani’s new beta, cost of equity and WACC if it has 30%, 40% and 50% debt? Determine the optimal capital structure of the Kushlani?

2. Using a graph show the Cost of Equity of Kushlani at different level of debt and highlight the premium for business risk and financial risk?   

(Please provide detailed answer)

Answer 1

Q a) levered beta at 30% debt

= unlevered beta ( 1 + (1-tax) debt/ equity)

= 1.2 (1+(1-0.35) 0.30/0.70 )

= 1.2 (1+ (0.65) 0.4286)

= 1.2 (1+ 0.2786)

= 1.2 (1.2786)

= 1.5343

Cost of equity = risk free rate + beta (market risk premium)

= 6% + 1.5343 (4%)

= 6% + 6.1371%

= 12.14%

Cost of debt = ytm (1-tax rate)

= 8.25% (1-0.35)

= 8.25% (0.65)

= 5.3625%

WACC = Cost of debt × weight of debt + Cost of equity × weight of equity

= 5.3625% × 0.3 + 12.14% × 0.7

= 1.61% + 8.50%

= 10.11%

Levered beta at 40% debt

= unlevered beta ( 1 + (1-tax) debt/ equity)

= 1.2 (1+(1-0.35) 0.40/0.60 )

= 1.2 (1+ (0.65) 0.6667)

= 1.2 (1+ 0.4333)

= 1.2 (1.4333)

= 1.72

Cost of equity = risk free rate + beta (market risk premium)

= 6% + 1.72 (4%)

= 6% + 6.88

= 12.88%

Cost of debt = ytm (1-tax rate)

= 8.5% (1-0.35)

= 8.5% (0.65)

= 5.525%

WACC = Cost of debt × weight of debt + Cost of equity × weight of equity

= 5.525% × 0.4 + 12.88% × 0.6

= 2.21% + 7.728%

= 9.94%

Levered beta at 50% debt

= unlevered beta ( 1 + (1-tax) debt/ equity)

= 1.2 (1+(1-0.35) 0.50/0.50 )

= 1.2 (1+ (0.65) 1)

= 1.2 (1+ 0.65)

= 1.2 (1.65)

= 1.98

Cost of equity = risk free rate + beta (market risk premium)

= 6% + 1.98(4%)

= 6% + 7.92%

= 13.92%

Cost of debt = ytm (1-tax rate)

= 9% (1-0.35)

= 9% (0.65)

= 5.85%

WACC = Cost of debt × weight of debt + Cost of equity × weight of equity

= 5.85% × 0.5 + 13.92% × 0.5

= 2.925% + 6.96%

= 9.89%

The optimal capital structure is at 50% debt when the weighted average cost of capital is the least.

B) Graph of cost of equity at different debt levels.

From the hraph we can see that as the level of debt is incresing the premium for financial and business risk is increasing, which leads to an increase in cost of equity.