Question

PLEASE ANSWER IN EXCEL

Macbeth Spot Removers is entirely equity financed.

Use the following information. Data Number of shares 2,200 Price per share $ 34 Market value of shares $ 74,800 Expected operating income $ 11,220 Return on assets 15%

Macbeth now decides to issue $37,400 of debt and to use the proceeds to repurchase stock. Suppose that Ms. Macbeth's investment bankers have informed her that since the new issue of debt is risky, debtholders will demand a return of 11.3%, which is 2.7% above the risk-free interest rate. Assume corporate tax rate is zero.

A. What are the company’s overall cost of capital after the debt issue?

B. What is the cost of equity after the debt issue?

C. Suppose that the beta of the unlevered stock was 0.60. What will βA, βE, and βD be after the change to the capital structure?

Answer 1

Solution:

Computing requirement B first,

B.

Cost of equity:

For calculating the cost of equity we can use CAPM( capital asset pricing model) formula i.e

CAPM = risk free rate + beta (market rate - risk free rate )

as given I risk-free rate is 2.7% less than the debt rate which is 11.3%

so,

risk-free rate = 8.6

(11.3-2.7)

   market rate = 11.3

BETA=0.6

CAPM = 8.6+0.6(11.3-8.6)

CAPM =10.22%

Therefore,

The cost of equity = 10.22%

A .

Cost of capital :

Cost of capital = cost of equity *weight of equity + cost of debt * weight of debt

cost of debt = debt interest rate *(1-tax)

as the tax rate is zero so Cost of debt = 11.3%

weight of equity = equity / (equity + debt)

=74,800 / (74,800+37,400)

=74,800 / 112,200

weight of equity = 0.6666

weight of debt = 37400/74800+37400

weight of debt   = 0.33333

Overall cost of capital = 10.22*0.6666+11.33*0.3333

=0.06812+0.03776

=0.1058

Overall cost of capital  = 10.58%

C.

Asset beta = equity beta /1+(1-tax)* debt /equty

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

=0.6*(1+(1-0))*(37400/74800)

equity beta( levered) =0.6*2*0.5

equity beta( levered)= 0.6

Asset beta = 0.6 / (1+(1-0))*(37400/74800)

=0.6 / (2*0.5)

= 0.6 / 1

Asset beta = 0.6

----------HOPE THIS IS HELPFUL