Question

Quantitative Problem: Currently, Meyers Manufacturing Enterprises (MME) has a capital structure consisting of 35% debt and 65% equity. MME's debt currently has a 7.4% yield to maturity. The risk-free rate (r_RF) is 5.4%, and the market risk premium (r_M – r_RF) is 6.4%. Using the CAPM, MME estimates that its cost of equity is currently 11%. The company has a 40% tax rate.

a. What is MME's current WACC? Round your answer to 2 decimal places. Do not round intermediate calculations.
____%

b. What is the current beta on MME's common stock? Round your answer to 4 decimal places. Do not round intermediate calculations.

c. What would MME's beta be if the company had no debt in its capital structure? (That is, what is MME's unlevered beta, b_U?) Round your answer to 4 decimal places. Do not round intermediate calculations.

MME's financial staff is considering changing its capital structure to 45% debt and 55% equity. If the company went ahead with the proposed change, the yield to maturity on the company's bonds would rise to 7.9%. The proposed change will have no effect on the company's tax rate.

d. What would be the company's new cost of equity if it adopted the proposed change in capital structure? Round your answer to 2 decimal places. Do not round intermediate calculations.
____%

e. What would be the company's new WACC if it adopted the proposed change in capital structure? Round your answer to 2 decimal places. Do not round intermediate calculations.
____%

Answer 1

a) WACC = W_d*K_d*(1-t) + W_e*K_e = 0.35*7.4%*(1-0.4) + 0.65*11% = 8.70%

b) Cost of equity = Risk free rate + Beta*Market risk premium

11% = 5.4% + Beta*6.4%

Beta = 0.8750

c) Unlevered beta = Levered Beta/(1+(1-t)*D/E) = 0.8750/(1+(1-0.4)*0.35/0.65) = 0.6613

d) New levered beta = Unlevered beta * (1+(1-t)*D/E) = 0.6613*(1+(1-0.4)*0.45/0.55) = 0.9859

Cost of equity = Risk free rate + Beta*Market risk premium = 5.4% + 0.9859*6.4% = 11.71%

e) WACC =  W_d*K_d*(1-t) + W_e*K_e = 0.45*7.9%*(1-0.4) + 0.55*11.71% = 8.57%