Question

Subaru Company has unleveraged beta 1.8, risk free rate 2% and market risk premium for 5%. The applicable tax rate is 30%.
The company needs to finance its new project having two different scenarios of financing:

Scenario Debt Ratio Interest rate (before tax) EPS
1 40% 10% $2.4
2 60% 13% $2.5

1: Beta Leveraged under scenario 1 and 2 are respectively: *

2.64 &3.69

3.44 & 2.79

3.25 & 3.55

1.62 & 1.95

2: After tax Cost of debt under scenario 1 and 2 are *

7.5% & 9.9%

7% & 9.1%

8.5% & 9.5%

9.2% & 8.7%

3: Cost of equity (rs) under scenario 1 and 2 are *

15.2% & 20.45%

16.5% & 18.25%

17.2% & 21.42%

18% & 16%

4: Calculate WACC under scenario 1 *

10.94%

13.64%

14.55%

11.92%

5 : Calculate WACC under scenario 2 *

10.94%

13.64%

14.55%

11.92%

6: Find the price per share under scenario 1 *

$14.75

$15.35

$15.79

$12.22

7: Find the price per share under scenario 2 *

$14.75

$15.35

$15.79

$12.22

8: The optimal Capital Structure is under which of the following scenario(s) *

Scenario 1

Scenario 2

Scenario 1&2

None of them

Answer 1

Debt ratio = 40%

Equity = 60%

D/E = 40/60 = 2/3

Beta(L) = Beta(U)*(1+(1-tax)*D/E) = 1.8*(1+(1-30%)*2/3) = 2.64

Debt ratio = 60%

Equity = 40%

D/E = 60/40 = 3/2

Beta(L) = 1.8*(1+(1-30%)*3/2) = 3.69

1: 2.64 & 3.69

After-tax cost of debt

scenario1 = 10%*(1-30%) = 7%

scenario2 = 13%*(1-30%) = 9.1%

2: 7% & 9.1%

Cost of equity

Scenario1 = 2%+2.64*5% = 15.2%

Scenario2 = 2%+3.69*5% = 20.45%

3: 15.2% & 20.45%

WACC

Scenario1 = 40%*7%+60%*15.2% = 11.92%

Scenario2 = 60%*9.1%+40%*20.45% = 13.64%

4: 11.92%

5: 13.64%

Price per share = EPS/(cost of equity)

Scenario1 = 2.4/15.2% = 15.79

Scenario2 = 2.5/20.45% = 12.22

6: 15.79

7: 12.22

The optimal capital structure should result in a higher share price

8: Scenario1