Beckman Engineering and Associates (BEA) is considering a change in its capital

Question

Beckman Engineering and Associates (BEA) is considering a change in its capital structure BEA currently has $20 million in debt carrying a rate of 8%, and its stock price is $40 per share with 2 millions shares outstanding. BEA is a zero growth firm and pays out all of its earnings as dividends. EBIT is $14,933 millions, and BEA faces a 40% debt, federal plus-rate-tax rate. The market risk premium is 4%, and the risk-free rate is 6%. BEA is considering increasing its debt level to a capital structure with 40% debt, based on market values, and repurchasing shares with the extra money that it borrows. BEA will have to retire the old debt in order to issue new debt, and the rate on the new debt will be 9%. BEA has a beta of 1.0.

A- What is BEA's unlevered beta? Use market value D/S when unlevering.
B- What are BEA's new beta and cost of equity if it has 40% debt?
C- What are BEA's WACC and total value of the firm with 40% debt?.

Explanation / Answer

ßU = ßL/[(1 + (1 - T)(D/E)] = 1.0/[1 + (1 - .40)(20/80)] = .870. Hence the unlevered beta is 0.870 B- What are BEA’s new beta and cost of equity if it has 40% debt? Solution: Computation of the new beta and Cost of Equity ßL = ßU[(1 + (1 - T)(D/E)]. At 40% debt, ßL = .87[1 + .6(40/60)] =1.218 Hence the New beta is 1.218 rs = Rrf + ßL (Rm – Rrf) = 6% + 1.218(4%) = 10.872%. Hence the cost of equity is 10.872% C- What are BEA’s WACC and total value of the firm with 40% debt? Solution: Computation of the WACC WACC = .4(9%)(1 - .4) + .6(10.872%) = 8.683%. WACC = 8.683% Hence the WACC is 8.683% V = FCF/WACC = [EBIT (1 - T)]/WACC = [14.933(.6)]/.08683 = $103.188 million. Hence the value of the firm is $103.188 million. Feel free to revert for any further clarification Cheers PK!

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