Question

Macbeth Spot Removers is entirely equity financed. Use the following information.

Data
Number of shares	2,800
Price per share	$46
Market value of shares	$128,800
Expected operating income	$19,320
Return on assets	15%

Macbeth now decides to issue $64,400 of debt and to use the proceeds to repurchase stock. Suppose that Ms. Macbeth's investment bankers have informed her that since the new issue of debt is risky, debtholders will demand a return of 10.7%, which is 3.3% above the risk-free interest rate.

a. What are r_A and r_E after the debt issue? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.)

Return on assets	%
Return on equity	%

b. Suppose that the beta of the unlevered stock was .60. What will β_A, β_E, and β_D be after the change to the capital structure? (Do not round intermediate calculations. Round your answers to 2 decimal places.)

Asset beta
Debt beta
Equity beta

Answer 1

Current return on assets =15 %

Return on assets = Net income / Total assets

15 % = 19320 / Total assets

Total assets = 19320 / 15% = 128,800

Net income after the debt issue = operating income - interest expense

= 19320 - 64400* 10.7%

= 19320 - 6890.80

= 12429.20

Return in assets = 12429.20 / 128800

= 9.65%

Return on equity = Net income / shareholders equity

No of shares bought back = 64400 / 46 = 1400

Shareholders equity = 46 *1400 = 64400

Return on equity = 12429.20 / 64400

= 19.30%

Asset beta = beta of the unlevered stock = 0.60

Equity beta = Unlevered beta * 1 + ( 1 - tax rate) * Debt / Equity

= 0.60 * [1 + 0.50 / 0.50 ]

= 0.6 * 2

= 1.20

Generally debt is considered to be risk free although its not here. The bondholders are asking an extra 3.3%.

Debt beta = 3.3%