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 million shares outstanding. BEA is a zero-growth firm and pays out all of its earnings as dividends. The firm's EBIT is $14.933 million, and it faces a 40% federal-plus-state 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 (which is the same as wd/ws) 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

a.) What is BEA's unlevered beta? USe market value D/S (which is the same as wd/ws) when unlevering.

Current Value of Equity = 40*2 = $ 80 Million

Current Value of Debt = $ 20 Million

D/E = 20/80

D/E = 1/4

BEA's unlevered beta = Levered Beta/(1+(1-tax rate)*D/E)

BEA's unlevered beta = 1.0/(1+ (1-40%)*1/4)

BEA's unlevered beta = 0.8696

b.) What are BEA's new beta and cost of equity if it has 40% debt?

BEA's new beta = BEA's unlevered beta* (1+(1-tax rate)*D/E)

BEA's new beta = 0.8696*(1+(1-40%)*40%/60%)

BEA's new beta = 1.22

c.) What are BEA's WACC and total value of the firm with 40% debt?

As per CAPM

Cost of Equity = risk free asset + market risk premium*beta

Cost of Equity = 6% + 4%*1.22

Cost of Equity = 10.88%

After tax cost of debt = 9%*(1-40%)

After tax cost of debt = 5.40%

WACC = Weight of Equity*Cost of Equity + Weight*Debt*After tax Cost of Debt

WACC = 60%*10.88 + 40%*5.40

WACC = 8.69%

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