Question

Beckman Engineering and Associates (BEA) is considering a change in its capital structure. BEA currently has $20 million in debt carrying a rate of 8%, and its stock price is $40 per share with 2 million shares outstanding. BEA is a zero-growth firm and pays out all of its earnings as dividends. The firm’s EBIT is $14.933 million, and it faces a 40% federal-plus-state tax rate. The market risk premium is 4%, and the risk-free rate is 6%. BEA is considering increasing its debt level to a capital structure with 40% debt, based on market values, and repurchasing shares with the extra money that it borrows. BEA will have to retire the old debt in order to issue new debt, and the rate on the new debt will be 9%. BEA has a beta of 1.0. What is BEA’s unlevered beta? Use market value D/S (which is the same as ) when unlevering. What are BEA’s new beta and cost of equity if it has 40% debt? What are BEA’s WACC and total value of the firm with 40% debt?

Answer 1

Equity = $40 * 2 = $80 million

Debt = $20 million

Calculation of unlevered beta:

_L=_U where D=Debt, E=Equity, t=tax rate, L= Levered and U=Unlevered

_U=_L

= 1/(1+(20/80)(1-0.4))

= 0.869 (Answer)

Calculation of levered beta with new debt structure:

_L=_U

=0.869 (1 + (40/60)(1-0.4))

=1.217 (Answer)

Calculation of cost of equity:

K_e= R_f + (R_m - R_f)*

= 6 + 4*1.217

= 10.868% (Answer)

Calculation of WACC:

WACC = K_e*W_e + K_d*(1-t)*W_d where K_e= weight of equity & K_d=Weight of debt

WACC = 10.868*0.6 + 9*(1-0.4)*0.4

= 8.68% (Answer)

Calculation of total value of the firm:

Value = FCF/WACC where FCF=Free cash flow to the firm

Value = (EBIT)*(1-t) / (WACC)

= 14.933*(1-0.4) / 0.0868

= $103.2235 million (Answer)