Beckman Engineering and Associates (BEA) is considering a change in its capital
ID: 2777550 • Letter: B
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 7%, and its stock price is $40 per share with 2 million shares outstanding. BEA is a zero growth firm and pays out all of its earnings as dividends. The firm's EBIT is $14.891 million, and it faces a 30% federal-plus-state tax rate. The market risk premium is 4%, and the risk-free rate is 5%. BEA is considering increasing its debt level to a capital structure with 30% 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 8%. BEA has a beta of 0.9.
Explanation / Answer
Calculation of unlevered beta:
Current capital structure
Debt = 20 million
Equity = 40 x 2 million = 80 million
D/E ratio = 20/80 = 0.25
Levered beta = 0.90
Unlevered beta = Levered beta / (1+(1-t)xD/E)
= 0.90/(1+(1-0.30)x0.25)
=0.90/1.175
= 0.766
Calculation of new beta
New D/E = 0.3/0.7
Levered beta = unlevered beta x (1+(1-t)xD/E)
= 0.766x(1+(1-0.30)x0.3/0.7)
=0.766 x 1.30
=0.996
Cost of equity = Rf + MRP x beta
= 0.05 +0.04x0.996
=8.98%
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