uantitative Problem: Currently, Meyers Manufacturing Enterprises MME has a capit

Question

uantitative Problem: Currently, Meyers Manufacturing Enterprises MME has a capital structure consisting of 35% debt and 65% equity. MME's debt currently has a 6.8% yield to maturity. The risk-free rate nr) is 4.8%, and the | market risk premium (rM-rRe) is 5.8%. Using the CAPM, MME estimates that its cost of equity is currently 10.8%. The company has a 40% tax rate. a. What is MME's current WACC? Round your answer to 2 decimal places. Do not round intermediate calculations b. What is the current beta on MME's common stock? Round your answer to 4 decimal places. Do not round intermediate calculations. c. What would MME's beta be if the company had no debt in its capital structure? (That is, what is MME's unlevered beta, bu?) Round your answer to 4 decimal places. Do not round intermediate calculations. MME's financial staff is considering changing its capital structure to 45% debt and 55% equity. If the company went ahead with the proposed change, the yield to maturity on the company's bonds would rise to 7.3%. The proposed change will have no effect on the company's tax rate d. What would be the company's new cost of equity if it adopted the proposed change in capital structure? Round your answer to 2 decimal places. Do not round intermediate calculations. e. What would be the company's new WACC If it adopted the proposed change in capital structure? Round your answer to 2 decimal places. Do not round intermediate calculations. f. Based on your answer to Part e,would you advise MME to adopt the proposed change in capital structure?

Explanation / Answer

a. Weight of Debt = 35%

Weight of Equity = 65%

Cost of Debt = 6.8%

Cost of Equity = 10.8%

Tax rate = 40%

MME’s WACC = Weight of Debt * Post tax cost of Debt + Weight of Equity * Cost of Equity

Or MME’s WACC = 0.35*6.8% (1-0.4) + 0.65* 10.8 = 8.45%

b. Cost of Equity = 10.8%

Risk Free Rate = 4.8%

Market Risk Premium = 5.8%

So, as per CAPM = Risk Free Rate + Beta* (Market Risk Premium)

10.8% = 4.8% + Beta* 5.8%

6% = 5.8% * Beta

Beta =1.03

c. Levered Beta = Unlevered Beta * [1 + (Debt/equity* (1-t))]

Unlevered Beta = 1.03/ [1 + ((0.35/0.65)*0.6)]

Unlevered Beta = 1.03/ 1.215 = 0.78

Now if the company did not have any debt in its capital structure then debt/equity will be 0, so in this case, the unlevered beta will be the levered beta with a value of 0.78

d. The Company is planning to change its capital structure to Debt 45% and equity 55%

So, Levered Beta = 0.78* [1+ (0.45/0.55*0.6)] = 1.16

Cost of New Equity = Risk Free Rate + Beta* (Market Risk Premium)

Or, Cost of New Equity = 4.8% + 1.16*5.8% = 11.53%

e. Cost of New Equity = 11.53%

Cost of New Debt = 7.3%

Weight of Debt = 45%

Weight of Equity = 55%

Cost of Capital = Weight of Debt * Post tax cost of Debt + Weight of Equity * Cost of Equity

Or, WACC = 45%* 7.3 %*( 1-0.4) + 55%* 11.53% = 8.31%

f. Based on Part e, the new cost of WACC is 8.31% while in comparison to the old one is 8.45% so the company can adopt the changes as it brings the overall cost of the funds.

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