Currently, Bloom Flowers Inc. has a capital structure consisting of 20 percent d

Question

Currently, Bloom Flowers Inc. has a capital structure consisting of 20 percent debt and 80 percent equity. Bloom's debt currently has an 8 percent yield to maturity. The risk-free rate (rRF) is 5 percent, and the market risk premium (rM-rRF) is 6 percent. Using the CAPM, Bloom estimates that its cost of equity is currently 12.5 percent. The company has a 40 percent tax rate.

Bloom's financial staff is considering changing its capital structure to 40 percent debt and 60 percent equity. If the company went ahead with the proposed change, the yield to maturity on the company's bonds would rise to 9.5 percent. 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?
e. What would the company's new WACC be if it adopted the proposed change in capital structure?
f. Based on your answer to part e, would you advise bloom to adopt the proposed change in capital structure? Explain.

Explanation / Answer

d) Cost of equity, rs= rRF + (rM-rRF)(Beta) Beta leveraged at 20% Debt = (14% - 5%)/6% = 1.5 Leveraged Beta = Unleveraged Beta[1+(1-T)(Debt/Equity)] Unleveraged Beta = 1.5/[1+(1-40%)(20%/80%)] = 1.304347 Leveraged Beta at 40% Debt = 1.304347[1+(1-40%)(40%/60%)] = 1.8260 New Cost of Equity, rs= 5% + (6%)1.8260 = 15.9565% = 15.96% (2DP) e) WACC = wdrd(1-T) + wcrs = 40%(9.5%)(1-40%) + 60%(15.96%) = 11.823% = 11.82% (2DP) f) Old WACC = 20%(8%)(1-40%) + 80%(12.5%) = 10.96% (2DP) New WACC > Old WACC Thus i would not advise Bloom to adopt the proposed change in capital structure as their cost of capital would increase

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