Question

Currently LowDebt Inc. has 5% debt in its capital structure.The debt is riskless and yields an expected return of 2%. LowDebt has an equity beta of 0.9. and its the stock market expected return is 15%. LowDebt’s market capitalization is currently $720 million. A junior analyst at the firm has suggested the firm recapitalizes by increasing the proportion of debt to 70% by paying a one-time special dividend and issuing debt for the amount of this dividend. She estimates that following this change the company’s debt would have an expected return of 9%. It seems that she has convinced the CEO to move forward with this recapitalization.

a What is the debt beta, the asset beta, and the cost of capital of the company before the refinancing?

b What is the total value of the company before the recapitalization? What is the amount of debt issued and the dividend paid?

c What is the beta of the common stock after the refinancing? What is the required rate of return on the common stock after the refinancing?

d How has the wealth of each individual shareholder changed? Assume that the debt is privately placed, so shareholders do not buy the debt issued.

e Using the same assumptions as in 4.d, how has the beta of the portfolio of the holders of common stock changed as a result of the refinancing? How could the shareholders invest in the market portfolio to restore the risk of their portfolio to what it was before the refinancing?

Answer 1

Refinancing risk refers to the possibility that an individual or company would not be able to replace a debt obligation with new debt at a critical time for the borrower. Your level of refinancing risk is strongly tied to your credit rating. To avoid refinancing risk, lenders place great value on a borrower's history of paying down his or her debt reliably. However, external factors—such as interest rate movements and the overall condition of the credit market—often play an even larger role in a borrower's ability to refinance.