1.Quantitative Problem: Currently, Meyers Manufacturing Enterprises (MME) has a

Question

1.Quantitative Problem: Currently, Meyers Manufacturing Enterprises (MME) has a capital structure consisting of 35% debt and 65% equity. MME's debt currently has a 7% yield to maturity. The risk-free rate (rRF) is 5%, and the market risk premium (rM – rRF) is 6%. Using the CAPM, MME estimates that its cost of equity is currently 11.6%. 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.
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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.
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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 7.5%. 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.
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Explanation / Answer

a. Weight of equity = We = 0.65. weight of debt = wd = 0.35

Cost of equity = Re = 11.6% and After tax cost of debt = Rd = Pretax rate*(1-tax rate) = 7*(1-0.4) = 4.2%

So WACC = We*Re + Wd*Rd = 0.65*11.6 + 0.35*4.2 = 9.01%

b. The CAPM equiation is Re = Rf + beta*(Rm-Rf)

Re= 11.6

Rf = 5%

Rm-Rf = 6%

11.6 = 5 + beta*6

Beta = 6.6/6 = 1.1

c.Beta Levered = Beta unlevered*(1+(1-T)*D/E)

beta levered = 1.1, T = 0.4 and D/E = 35/65 =0.5385

1.1 = Beta Unlevered *(1+(1-0.4)*0.5385)

Unlevered Beta = 0.8148 = 0.81

d. New beta would be = Beta unlevered*(1+(1-T)*D/E)  =0.81*(1+(1-0.4)*45/55) = 1.21

So Cost of equity = 5 + 1.21*6 = 12.26%

e.

Weight of equity = We = 0.55. weight of debt = wd = 0.45

Cost of equity = Re = 12.26% and After tax cost of debt = Rd = Pretax rate*(1-tax rate) = 7.5*(1-0.4) = 4.5%

So WACC = We*Re + Wd*Rd = 0.55*12.26 + 0.45*4.5 = 8.768%

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