The company Youphone is expected to generate $48 million in FCFF next year. The
ID: 2743789 • Letter: T
Question
The company Youphone is expected to generate $48 million in FCFF next year. The firm currently is extremely over-levered with a debt to equity ratio of 4:1. The beta of the stock is now 2.72 and the pre-tax cost of debt is 12%. The marginal tax rate is 40%, the risk free rate is 4% and the market risk premium is 6%. You believe that new management can turn the firm around by restructuring the firm’s financing mix, to make it 50% debt and 50% equity. That will reduce the pre-tax cost of debt to 8%. The firm is expected to have a 2% perpetual growth rate.
What would be the new cost of equity under the new financial structure?
a. 19.44%
b. 6.24%
c. 11.68%
d. 10.24%
e. None of the other answers.
Explanation / Answer
Levered beta = 2.72
Debt Equity ratio = 4:1
Let’s assume tax rate = 40%.
Unlevered beta is calculated below using following formula:
Unlevered beta = beta (levered) / 1 + (1 - tax rate) x (Debt/Equity)
= 2.72 / [1+ (1 – 40%) × (4 / 1)]
= 2.72 / [1+ 2.4]
= 0.80
Hence, unlevered beta at tax rate of 40% is 0.80
Now management of company wants to restructure its capital structure and wants 50% debt and 50% equity.
So new levered beta with 50% debt and 50% equity is calculated below:
Beta (levered) = Unlevered beta × [1 + (1 - tax rate) x (Debt/Equity)]
= 0.80 × [1 + (1 - 40%) × (50% / 50%)]
= 0.80 × (1+ 0.6)
= 1.28
New levered beta with 50% debt and 50% equity is 1.28.
Hence, Option (C) is correct answer.
New Beta is 1.28.
Risk Free rate = 4%
Risk Premium = 6%
New cost of equity is calculated below using CAPM model:
Cost of equity = Risk free rate + Risk Premium × Beta
= 4% + 6% × 1.28
= 4% + 7.68
= 11.68%
New Cost Of equity is 11.68%.
Hence, Option (C) is correct answer.