Please show step by step how the problem is solved. Speedy Auto Parts is conside
ID: 2753537 • Letter: P
Question
Please show step by step how the problem is solved.
Speedy Auto Parts is considering a merger with Freeman Car Parts. Freeman's market-determined beta is 0.9, and the firm currently is financed with 20% debt, at an interest rate of 8%, and its tax rate is 25%. If Speedy acquires Freeman, it will increase the debt to 60%, at an interest rate of 9%, and the tax rate will increase to 35%. The risk-free rate is 6% and the market risk premium is 4%.
a)Calculate the current required return to Freeman's equity
b)Calculate Freeman's unlevered cost of equity?$
c)What will be Freeman's required rate of return on equity after it is acquired? Hint: Calculate Workman's levered cost of equity at the new capital structure with the new cost of debt.
Explanation / Answer
Risk Free Rate =Rf= 6.00% Marker Premium=Rm-Rf= 4.00% Beta Freeman 0.90 a Current Required rate of Return Freeman Equity =Rf +Beta*(Rm-Rf) =0.06+0.90*0.04 = 9.60% Current Required rate of Return Freeman =9.6% b Assume unlevered equity cost of Frreman = Kug Levered cost of equity =kg= 9.60% Tax rate = 25% Debt Interest rate =Kd 8% D/E =20/100 Kg=Kug+(1-T)*D/E(Kug-Kd) 0.096=Kug+0.75*0.20*(Kug-0.08) 0.096=Kug +0.15Kug-0.012 0.096=1.15Kug-0.012 Kug=9.39% So Unlevered cost of equity= 9.39% c After acquiring by Speedy Cost of Debt=Kd= 9% Debt /Equity =60/100 Tax rate =T= 35% Unlevered cost of Equity=Kug= 9.39% Assume cost of levered equity after cahnge in capital structure =kg Kg=Kug+(1-T)*D/E(Kug-Kd) =0.0939+0.65*0.60*(0.0939-0.09) =0.0939+0.0015 =9.54% After Freeman is acquired , its required rate of return for equity is =9.54%