Question

Beckman Engineering and Associates (BEA) is considering a change in its capital structure. BEA currently has $20 million in debt carrying a rate of 8%, and its stock price is $40 per share with 2 million shares outstanding. BEA is a zero growth firm and pays out all of its earnings as dividends. The firm's EBIT is $14.276 million, and it faces a 40% federal-plus-state tax rate. The market risk premium is 6%, and the risk-free rate is 7%. BEA is considering increasing its debt level to a capital structure with 50% debt, based on market values, and repurchasing shares with the extra money that it borrows. BEA will have to retire the old debt in order to issue new debt, and the rate on the new debt will be 15%. BEA has a beta of 1.2.

What is the total value of the firm with 50% debt? Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. Do not round intermediate calculations. Round your answer to three decimal places.
$   million

1. What is BEA's unlevered beta? Use market value D/S (which is the same as w_d/w_s) when unlevering. Do not round intermediate calculations. Round your answer to two decimal places.
2. What are BEA's new beta and cost of equity if it has 50% debt? Do not round intermediate calculations. Round your answers to two decimal places.
   Beta:
   Cost of equity:   %
3. What are BEA’s WACC and total value of the firm with 50% debt? Do not round intermediate calculations. Round your answer to two decimal places.
     %

Answer 1

Unlevered Beta = βU

Levered Beta = βL = 1.2

t = tax rate = 40% = 0.40

D = Debt Level = $20 million

E = Equity Level = No of Shares O/S * Price per share = $40 per share * 2 Million = $ 80 million

βU = 1.2 / 1.15 = 1.04

Ans a : BEA's unlevered beta = 1.04

Now BEA is targeting for D/E level of 50%.

D/E = 0.5

Levered Beta = βL = 1.2

t = tax rate = 40% = 0.40

βU = 1.2 / 1.3 = 0.923

Cost of Equity Ke

Ke = Rf + ( Rm - Rf) *βU

he market risk premium is 6%, and the risk-free rate is 7%

Rf =  risk-free rate is 7% = 0.07

( Rm - Rf) =  market risk premium is 6% = 0.06

Ke = Rf + ( Rm - Rf) *βU = 0.07 + 0.06 * 0.923 = 0.12538 = 12.538%

Ans b : BEA's new beta = 0.923

and cost of equity = 12.538%

BEA’s WACC

WACC = Wd * Kd * ( 1 - t) + We * Ke

Wd = Weightage of Debt = 50% = 0.50

We = Weightage of Equity = 1 - Wd = 1 - 50% = 50% = 0.50

t = tax rate = 40% = 0.40

Kd = Cost of Debt = 15% = 0.15

WACC =0.5 * 0.15 * ( 1 - 0.4 ) + 0.5 * 0.12538 = 0.10769 = 10.769%

Ans : BEA’s WACC   = 10.769%

So Value of the Firm

Value = EBIT (1 - t ) / WACC = 14.276 * ( 1 - 0.4 ) / 10.769% =$ 79.539 million

Ans : total value of the firm = $ 79.539 million