Question

For this and the next question: Octane Music currently has $40 million of debt at 9 percent interest rate. Its stock price is $40 per share with 4 million shares outstanding. Octane is a zero-growth firm. The company's EBIT is $29.866 million, tax rate is 40 percent, market risk premium is 5 percent, risk free interest rate is 6 percent. Octane is considering increasing its debt ratio to 40 percent (based on market values) and buying back some shares with the extra borrowed funds. Interest rate on the new debt will be 10 percent. Octane's beta is currently 2.0. Calculate Octane's unlevered beta (please use market value debt-to-equity ratio)

A. 0.87

B. 1.21

C. 1.74

D. 2.24

E. None of the above

QUESTION 2: Calculate Octane's new beta (levered beta) with 40 percent debt ratio

A. 0.87

B. 1.21

C. 1.60

D. 2.24

E. None of the above

Answer 1

The unlevered Beta for Octane is :

Beta / [ 1 + (1 - tax rate) * Debt/ Equity ]

= 2/ [ 1 +( 0.6) * ($40/ $160) ]

= 1.7391

= 1.74

SO, the correct option is option C.

Levered Beta of Octane is :

Levered Beta = unlevered Beta [ 1 + (1-tax rate) *(Debt/ Equity)

Now, the new capital structure consists of 40% debt and 60% equity,

So, the market value of debt is = 40% * $200 million

= $80  million

The market value of equity is = 60% * $200

= $120

So, the levered beta is :

= 1.74 [ 1 + (0.6) * ( $80)/($120 )] [ using market value debt- equity ratio]

= 2.436

= 2.44

So, the correct option is none of the above, option E.