Question

Currently ABM Corp beta is 1.26. The market value of debt is $50M, and the market value of assets is 90M. The company is considering repurchasing its bonds for $10M and issuing common stock for the same amount. The company pays 22% taxes on its profits. What is the new beta if risk-free rate is 4.7% and the return on stock market is 9.2%.

Answer 1

Here Market value of Debt = $50M

And Market value of equity = Market value of asset - Market value of Debt

=90M -50M = $40M

First of all lets find unlevered beta

Unlevered beta = Levered beta / [ 1 + (1-tax rate) x Debt / Equity]

Here Levered beta = 1.26

Tax rate = 22%

Debt after issue of stock = $50 M - $10 M = $40 M

Equity after issue of stock = $40 M + $10M = $50M

Unlevered beta = 1.26/ [ 1 +(1-0.22) x (40/50) ]

=1.26 / [1 + (0.78)(0.80)]

=1.26 /[1+0.624]

=1.26/1.624

=0.78

Thus Required retun = Risk free rate of return + beta ( Return on stock market - Risk free rate of return)

=4.7% + 0.78(9.2% -4.7%)

= 4.7% + 0.78(4.5%)

=4.7% + 3.51%

=8.21%