For this and the next question: 1. Zeeland Furniture Company (ZFC) currently has
ID: 2753889 • Letter: F
Question
For this and the next question:
1. Zeeland Furniture Company (ZFC) currently has $50 million of debt at 10% interest rate. Its stock is selling for $25 per share, and there are 3 million shares outstanding. The firm's net operating income is expected to remain flat for the foreseeable future with EBIT at $31 million. Tax rate is 40%, expected market return is 11%, risk free interest rate is 6%. ZFC is considering raising its debt ratio to 45% (based on market values) and buying back some shares with the extra borrowed funds. Interest rate on the new debt will be 12%. ZFC's beta is currently 1.5. Calculate ZFC's unlevered beta using market value debt-to-equity ratio.
a. 0.87
b. 1.07
c. 1.74
2. Calculate ZFC's new beta (levered beta) given the projected 45% debt ratio. Be sure to use stored values to calculate your final result - this will help you avoid rounding errors.
a. 0.8701
b. 1.7391
c. 1.491
d. 1.5974
Explanation / Answer
1. Unlivered Beta (BU) is given byj the formula = BL/[1+(1-Tc)*(D/E)]
Now D/E = 50/(3*25) = 50/75 = 0.66, BL = 1.5, Tc = 40% =0.4
Hence Bu = 1.5/[1+(1-0.4)*0.66] = 1.5/1,4 = 1.07
Hence Unlevered Beta =1.07
2. The new Debt ratio is 0.45
Hence D/(D+E) = 0.45
Now the total debt + equity remains the same = 125
Hence new debt = D = 125*0.45 = 56.25
TSo the debt has increased by 6.25 and hence he equity will reduce by 6.25, E = 68.75
Hence New D/E ratio = 56.25/68.75 = 0.8182
Hence The new BL = Bu * [1+(1-Tc)*(D/E)]
BL = 1.07*(1+(1-0.4)*0.8182) = 1.5974
Hence new levered beta = 1.5974