Union Street Records is considering a new capital structure. The CFO has prepare
ID: 2750855 • Letter: U
Question
Union Street Records is considering a new capital structure. The CFO has prepared a list of options:
The company currently has a debt-to-capital ratio of 0.75 (option 4) and an equity beta of 1.9. The tax rate is 34%.
The risk-free rate is 2% and the expected equity market risk premium is 9%.
1. What is the unlevered beta?
2. Find the levered beta for each option. What is the levered beta for option 2 (debt-to-capital ratio of 0.25)?
3. Find the cost of equity for each option. What is the cost of equity for option 2 (debt-to-capital ratio of 0.25)?
4. Find the WACC for each option. What is the WACC for option 3 (debt-to-capital ratio of 0.5)?
5. What is the WACC at the optimal capital structure?
Option Debt-to-capital ratio Bond rating Interest rate 1 0 AA 0.04 2 0.25 BBB 0.05 3 0.5 B 0.07 4 0.75 C 0.09Explanation / Answer
Answer:1 Unlevered Beta=Levered Beta/(1+(1-t)(D/E))
=1.9/(1+(1-0.34)(0.75)
=1.9/1.495
=1.270
Answer:2 Levered beta=Unlevered beta*((1+(1-t)(D/E))
Option 1= 1.270((1+(1-0.34)(0)
=1.270
Option 2= 1.270((1+(1-0.34)(0.25))
=1.47955
Option 3= 1.270((1+(1-0.34)(0.5))
=1.6891
Option 4= 1.270((1+(1-0.34)(0.75))
=1.9
Answer:3 Ke=Rf+beta(Market risk premium)
Option 1=2%+1.270*9%
=13.43%
Option 2=2%+1.47955*9%
=15.32%
Option 3=2%+1.6891*9%
=17.20%
Option 4=2%+1.9*9%
=19.1%
Answer:4 WACC=Ke*We+Kd*Wd
Option 1=13.43%*100%+4%(1-0.34)*0%
=13.43%
Option 2=15.32%*0.75+5%(1-0.34)*0.25
=11.49%+0.825%
=12.315%
Option 3=17.20%*0.50+7%(1-0.34)*0.50
=8.6%+2.31%
=10.91%
Option 4=19.1%*0.25+9%(1-0.34)*0.75
=4.775%+4.455%
=9.23%
Answer:5 Optimal capital structure is the Option 4 .
Option 4=19.1%*0.25+9%(1-0.34)*0.75
=4.775%+4.455%
=9.23%
Because at this structure WACC is the minimum.
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