The following data pertains to Zolar Corp., a manufacturer of ball bearings (dol

Question

The following data pertains to Zolar Corp., a manufacturer of ball bearings (dollar amounts in millions). Total Assets $6,840 Interest-Bearing Debt $3,562 Average Pre-tax borrowing cost 11.5% Common Equity: Book Value $2,560 Market Value $12,850 Income Tax Rate 35% Market Equity Beta 1.24 Refer to the information for Zolar Corp. Company. Assume that Zolar is a potential leveraged buyout candidate. Assume that the buyer intends to put in place a capital structure that has 70 percent debt (with a pre tax borrowing cost of 14 percent) and 30 percent common equity. Compute the revised equity beta (i.e. new levered market beta) for Zolar based on the new capital structure. (Hint: Compute the unlevered market beta first and then compute the new levered market beta).

Explanation / Answer

Before buyout

Value of debt = $6,840

Market value of equity = $12,850

Beta = 1.24

Tax rate = 30%

First of all calculated unlevered beta as calculated below using following formula:

Unlevered beta = beta (levered) / 1 + (1 - tax rate) x (Debt/Equity)

                           = 1.24 / [1+ (1 – 30%) × ($6,840 / $12,850)]

                           = 1.24 / [1+ 0.3726]

                           = 0.903

Unlevered beta at tax rate of 30% is 0.903.

After buyout

Now company wants 70% debt and 30% equity. So levered beta is calculated below using following formula:

Beta (levered) = Unlevered beta × [1 + (1 - tax rate) x (Debt/Equity)]

                         = 0.903 × [1 + (1 - 30%) × (70% / 30%)]

                         = 0.903 × (1+ 1.63)

                         = 2.38

Hence, Levered beta is 2.38.

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