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 $13.516 million, and it faces a 30% federal-plus-state tax rate. The market risk premium is 4%, and the risk-free rate is 5%. BEA is considering increasing its debt level to a capital structure with 35% 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 8%. BEA has a beta of 1.1.
Beta | |
Cost of equity | % |
Answer :
a) ßU = ßL / [ (1 + ( 1 - T ) ( D / E ) ]
= 1.1 / [ 1 + ( 1 - 0.30 ) ( 20 / 80 ) ]
= 0.94
Therefore, the unlevered beta is 0.94
b) ßL = ßU [ ( 1 + ( 1 - T ) ( D / E ) ]
At 35% debt, ßL = 0.94 [ 1 + 0.70 ( 35 / 65 ) ]
ßL = 1.29
Hence the new beta is 1.29
rs = Rrf + ßL ( Rm - Rrf )
= 5% + 1.29 (4%)
= 10.16%
Hence, the cost of equity is 10.16%
c) WACC = Wd * rd (1 - t ) + We * rs
WACC = 0.35 * 8% ( 1 - 0.30 ) + 0.65 ( 10.16% )
WACC = 8.56%
Hence, the WACC is 8.56%
Value of the firm is calculated as follows:
V = EBIT( 1 - T ) / WACC
= 13.516 ( 1 - 0.30 ) / 8.56%
= $ 110.528 million
Therefore, the value of the firm is $ 110.528 million.
Get Answers For Free
Most questions answered within 1 hours.