Lincoln Funeral Home has a capital structure consisting of 20% debt and 80% equi
ID: 2718896 • Letter: L
Question
Lincoln Funeral Home has a capital structure consisting of 20% debt and 80% equity. Lincoln’s debt currently has an 8% yield to maturity. The risk free rate is 5% and the market risk premium is 7%. Using CAPM, Lincoln estimates that the cost of equity is currently 12.5%. The company has a 40% tax rate. The firm pays out all of its earnings as dividends. Lincoln currently has $30 million in debt and its stock price is $60 per share with 2 million shares outstanding. The free cash flow last year was $9 million. The CEO is considering changing the capital structure to 40% debt and 60% equity. If the company went ahead with this change their new cost of borrowing would be 9.5%. a) What would the company’s new WACC be if it adopts the proposed changes to the capital structure? Should the company go ahead with the new plan? b) Assuming that they go ahead with the plan, calculate the new value of the operations. How much has it changed by?
Explanation / Answer
New WACC = 10.76%
As there is an additional tax benefit of $ 20 Million due to new capital structure the company may go ahead with the proposed change
New Value of Operations = $ 83.64 Million
Additonal Value created = $ 1.53 Million
Existing structure
Debt - 20%
Equity - 80%
Ytm on debt - 8%
Risk free rate = 5%
Market risk premium = 7%
CAPM cost of equity = 12.5%
Tax rate = 40%
Current Market value of Debt = $ 30 Million
No of shares outstanding = 2 Million
Current Market Price = $ 60
Market Value of Equity = $ 60 * 2 Million = $ 120 Million
Debt / Equity ratio = $ 30 Million / $ 120 Million = 0.25
Free cash flow = $ 9 Million
CAPM cost of equity = 12.5%
As per CAPM, Expected return = risk-free rate + Beta * Market risk premium
12.5% = 5% + Beta * 7%
12.5% - 5% = Beta * 7%
7.5% = Beta * 7%
Levered Beta = 7.5%/7% = 1.071428 or 1.071 (rounded off)
Unlevered Beta = Levered Beta / (1+(1-tax rate)*(D/E))
= 1.071 / (1+(1-0.40)*0.25)
= 1.071 / (1+ 0.6 * 0.25)
= 1.071 / (1+0.15)
= 0.9313
Weighted average cost of capital in current structure
WACC1 = 0.8 * 12.5% + 0.2 * 8% * (1-0.40) = 10% + 0.96% = 10.96%
As the firm currently pays all its earnings as dividends, the retained earnings ratio = 0
Hence the value of the firm can be calculated as
Value of operations = Operating Cash Flows /WACC1
= $ 9 Million / 0.1096 = $ 82.116 Million
Changed structure
Target debt and equity proportions
Debt - 40%
Equity - 60%
Assuming that the equity stays the same then
Value of the firm = Equity / 0.6 = $ 120 Million / 0.6 = $ 200 Million
Total Debt of new structure = $ 200 Million * 0.4 = $ 80 Million
Debt / Equity Ratio = Debt / Equity = $ 80 Million / $ 120 Million = 0.6667
Value of levered Beta at this level = Unlevered Beta * (1+(1-tax rate)*(D/E))
= 0.9313 * (1+ (1-0.40)*0.6667)
= 0.9313 * (1+0.40002)
= 0.9313 * 1.40002
= 1.303838626 or 1.304 (rounded off)
Calculation of cost of equity using CAPM
Cost of Equity = risk-free rate + beta * Market risk premium
Cost of Equity = 5% + 1.304 * 7% = 5% + 9.128% = 14.128% or 14.13% (rounded off)
New cost of debt = 9.5% (as given in the problem)
Weighted Average cost of Capital of proposed capital structure
WACC2 = 0.6 * 14.13% + 0.4 * 9.5% * (1-0.40)
= 8.476% + 2.28%
= 10.756% or 10.76% (rounded off)
Tax benefits from current capital structure = tax rate * debt = 0.4 * $ 30 Million
= $ 12 Million
Tax benefits from new structure = tax rate * New debt amount = 0.4 * $ 80 Million
= $ 32 Million
Additional Tax benefit due to changed capital structure = $ 32 Million - $ 12 Million
= $ 20 Million
Assuming the OCF at the same level of $ 9 Million and the company continues with its policy of paying all its earnings as dividends, the value of operations will be
Value of operations = $ 9 Million / WACC2 = $ 9 Million /0.1076 = $ 83.643 or $ 83.64 Million (rounded off)
Value of operations under existing capital structure = $ 82.116 Million
Additional value created = $83.643 - $ 82.116 = $ 1.527 Million or $ 1.53 Million (rounded off)
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