Question

The A. J. Croft Company (AJC) currently has $200,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6 percent. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero-growth company. AJC's current unlevered beta is 0.5, and its tax rate is 40 percent. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00. The firm is considering moving to a capital structure that is comprised of 40 percent debt and 60 percent equity, based on market values. The new funds would be used to replace the old debt and to repurchase stock. It is estimated that the increase in riskiness resulting from the leverage increase would cause the required rate of return on debt to rise to 7 percent. The risk free rate is 6 percent and the market risk premium is 5 percent.

If this restructuring plan were carried out, what would be AJC’s new levered beta and new cost of equity?

Answer 1

Calculation of the levered beta using unlevered beta:-

Formula:-

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

Unlevered beta = 0.5

Tax rate = 40%

Debt = 40%

Equity = 60%

Levered beta = 0.5 * (1 + (1 - 0.40) * (0.40 / 0.60)

Levered beta = 0.50 * (1 + 0.4)

Levered beta = 0.70

Calculation of the New cost of equity:-

New cost of equity = Rf + beta * market risk premium

Rf = Risk free rate = 6%

Market risk premium = 5%

New cost of equity = 6% + 0.7 * 5%

New Cost of equity = 9.5%