Review this situation: Transworld Consortium Corp. is trying to identify its opt
ID: 2785774 • Letter: R
Question
Review this situation: Transworld Consortium Corp. is trying to identify its optimal capital structure. Transworld Consortium Corp. has gathered the following financial information to help with the analysis Debt Ratio Equity Ratio EPS DPS Stock Price 30% 40% 50% 60% 70% 70% 60% 50% 40% 30% 1.25 0.55 36.25 1.40 0.60 37.75 1.60 0.65 39.50 1.85 0.75 38.75 1.75 0.70 38.25 Which capital structure shown in the preceding table is Transworld Consortium Corp.'s optimal capital structure? Debt ratio = 50%; equity ratio = 50% Debt ratio = 30%; equity ratio = 70% Debt ratio = 60%; equity ratio = 40% Debt ratio = 70%; equity ratio = 30% Debt ratio = 40%; equity ratio = 60% Consider this case: Globex Corp. currently has a capital structure consisting of 40% debt and 60% equity. However, Globex Corp.'s CFO has suggested that the firm increase its debt ratio to 50%. The current risk-free rate is 3.5%, the market risk premium is 796, and Globex Corp.'s beta is 1.25 If the firm's tax rate is 45%, what will be the beta of an all-equity firm if its operations were exactly the same? Now consider the case of another company U.S. Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 8%, and its tax rate is 45%. It currently has a levered beta of 1.25. The risk-free rate is 3.5%, and the risk premium on the market is 7%. U.S. Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity Increasing the firm's level of debt will cause its before-tax cost of debt to increase to 10% First, solve for U.S. Robotics Inc.'s unlevered betaExplanation / Answer
a.
Stock price is maximum at 50% debt and 50% equity. SO optimal capital structure is 50% debt and 50% equity.
Option (A) is correct answer.
b.
At 40% debt level
Levered beta = 1.25
Tax rate = 45%.
Unlevered beta is calculated below using following formula:
Unlevered beta = beta (levered) / 1 + (1 - tax rate) x (Debt/Equity)
= 1.25 / [1+ (1 – 45%) × (40% / 60)]
= 1.25 / [1+ 0.37]
= 0.91
Hence, unlevered beta at tax rate of 45% is 0.91
Now management of company wants to restructure its capital structure and wants 50% debt and 50% equity.
So new levered beta with 50% debt and 50% equity is calculated below:
Beta (levered) = Unlevered beta × [1 + (1 - tax rate) x (Debt/Equity)]
= 0.91 × [1 + (1 - 45%) × (50% / 50%)]
= 0.91 × (1+ 0.55)
= 1.42
New levered beta with 50% debt and 50% equity is 1.42.
c.
Levered beta = 1.25
Tax rate = 45%.
Unlevered beta is calculated below using following formula:
Unlevered beta = beta (levered) / 1 + (1 - tax rate) x (Debt/Equity)
= 1.25 / [1+ (1 – 45%) × (30% / 70)]
= 1.25 / [1+ 0.1571]
= 1.08
Hence, unlevered beta at tax rate of 45% is1.08
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.