Question

Schroeder Electronics (Schroeder) is evaluating a new investment Project X, which is totally unrelated to its existing line of business. However, it has identified a publicly traded comparable firm ZES that is exclusively engaged in the same line of business as Project X. Additional information for ZES are given in the table below.

Debt outstanding (book value, AA- rated)	$ 50 million
Number of shares outstanding	50 million
Stock price per share	$10
Book value of Equity per share	$7
Beta of equity	1.4

Assume that Schroeder has a debt to equity ratio of 0.4 and a marginal tax rate of 28%. The current yield of Schroeder’s long term debt is 4.5%. The risk-free rate is 3% and the market risk premium is 5%.

1. Assume a debt beta of zero and estimate ZES’s asset beta using the information above.
2. Explain how debt features affect the beta of debt. When is it more suitable to assume that debt has a zero beta? (Please type your answer in no more than 50 words)

Answer 1

a). If debt beta is zero then asset beta is:

asset beta = equity beta/[1 + (1-Tax rate)*D/E) where equity beta = 1.4; Tax rate = 28%;

D/E ratio = debt value/equity value

Debt value = 50 million

Equity value = price per share*number of shares = 10*50 = 500 million

D/E ratio = 50/500 = 0.10

Asset beta of ZES = 1.4/(1+(1-28%)*0.10) = 1.31

b). A debt which has no market risk will have zero beta. How risky a debt is depends on its credit rating and hence, its credit spread. As credit spread of the debt increases, its beta is going to increase.