15-10- Optimal Capital Structure with Hamada (Challenging Problem) Beckman Engin

Question

15-10- Optimal Capital Structure with Hamada (Challenging Problem)

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 firms EBIT is $14.933 million. and it faces a 40% federal plus state tax rate. The market premium is 4% and the risk-free rate is 6%. BEA is considering increasing its debt level 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.

a. what is BEA's unlevered beta? Use market value D/S (which is the same as Wd/Ws) when unlevering.---Answer is: 0.870. Show all work and formulas to support answer.

b. What are BEA's new beta and cost equity of its 40% debt?--Answer is: 1.218; Rs = 10.872%--show all work and formulas to support answer.

c. What are BEA's WACC and total value of the firm with 40% debt?--Answer is: WACC = 8.683%; V = 103.188 million--show all work and formulas to support answer.

Explanation / Answer

Answer:

A.)

BEA's Unlevered Beta = ßU = ßL/[(1 (1 - T)(D/E)] = 1.0/[1 (1 - .40)(20/80)] = .870. Hence the unlevered beta is 0.870

B) at 40% Debt, BEA's new beta = 1.218, So Cost of equity = Risk free rate + MArket premium * Beta

= 6 + 4*1.218 = 10.872%

C) WACC = 0.10872 *60 + 0.09(1-.40) * 40 = 8.6832%

Value of firm = 103.188 Million

Thanks

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