Problem 16-10 Optimal Capital Structure with Hamada Beckman Engineering and Asso
ID: 2780776 • Letter: P
Question
Problem 16-10 Optimal Capital Structure with Hamada Beckman Engineering and Associates BEA is considering a change in its capital structure. BEA currently has $20 million in debt carrying a rate of 6%, 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 $12.631 million, and it faces a 35% federal-plus-state tax rate. The market risk premium is 6%, and the risk-free rate is 5%, BEA is considering increasing its debt level to a capital structure with 45% 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 11%. BEA has a beta of 1.0. a. What is BEA's unlevered beta before restructuring? Use market value D/S (which is the same as wd/ws) when unlevering. Round your answer to two decimal places. b, what are BEA's new beta after releveraging and cost of equity if it has 45% debt? Round your answers to two decimal places Beta Cost of equity c. What is BEA's WACC after releveraging? Round your answer to two decimal places what is the total value of the firm with 45 % debt? Enter your answer in millions. For example, an answer of $1 three decimal places. milion should be entered a 1 not ,20 Round your answer millionExplanation / Answer
a) BEA 's unlevered beta before restructuring
Current Debt in capital structure = $ 20 Million
Current Equity in capital structure = 40 * 2M = $ 80 Million
So D/V =20/(20+100) = 20%, D/E = 20/80 = 25%
Unlevered Beta = Beta Levered/(1+(1-t)*D/E) =1/(1+(1-35%)*0.25) = 1/(1+0.65*0.25) = 0.86
b) New Beta after relevering with 45% debt and 55% equity
D/E ratio = 0.818
Beta Levered = 0.86*(1+0.65*0.818)= 1.317 =1.32
Cost of Equity = Rf + Beta* MRP = 5% + 1.32*6% = 12.92 %
c) To find WACC, we need to first have the proportions of debt and equity(Wd and We)
Wd = 45%
We= 55%
Cost of debt, kd = 11%
Post tax cost of debt ,kd(1-t) = 11% * 0.65 = 7.15%
Ke= Cost of equity = 12.92%
WACC after releveraging = 7.15%*0.45 + 12.92%* 0.55 = 10.32%
Free Cash flow to the firm (FCFF) = EBIT*(1-t ) = 12.631* 0.65 = $ 8.21 M
As the growth in the firm is zero, the terminal value of firm is given by (FCFF/ WACC)
Value = 8.21/0.1032= $ 79.555 M