Mark IV Industries\' current debt to equity ratio is 0.4; it has a (levered) equ

Question

Mark IV Industries' current debt to equity ratio is 0.4; it has a (levered) equity and a cost of equity 15.2%. Risk free rate is 4%, the market risk premium is 8%, debt is 4%, and the corporate tax rate is 34%. The firm is in a mature business, i.e. it is not growing anymore. It has long-term debt outstanding that is rolled over when it matures, so that the amount of debt outstanding does not change. .4, the cost of beta of 1 Suppose the firm repurchases stock and finances its repurchase with debt, issued at the same cost of debt. As a result, its debt to equity ratio changes to 0.6. 1. What is the firm's WACC under current capital structure? 2. What is the firm's new equity beta? 3. What is the firm's new cost of equity? 4. What is the change in the cost of equity due to its business risk? 5. What is the change in the cost of equity due to its financial risk? 6. What is the WACC under the new capital structure?

Explanation / Answer

Current Capital Structure:

D/E=0.4

proportion of equity=E/(D+E)=1/(D/E+1)=1/1.4=0.7142857

proportion of debt=D/(D+E)=1/(1+1/(D/E))=1-proportion of equity=1-0.7142857=0.285714

t=34%

cost of equity=15.2%

cost of debt=4%

WACC=proportion of equity*cost of equity+proportion of debt*cost of debt*(1-tax rate)

=0.7142857*15.2%+0.285714*4%*(1-34%)

=11.61%

unlevered beta=levered beta/(1+(1-t)*D/E)

So, unlevered beta=1.4/(1+(1-34%)*0.4)=1.107595

New Capital Structure:

levered beta=unlevered beta*(1+(1-t)*D/E)

So, levered beta under new capital structure, or new equity beta=1.107595*(1+(1-34%)*0.6)=1.5462

new cost of equity=risk free+beta*market risk premium=4+1.5462*8=16.3696%

D/E=0.6

proportion of equity=E/(D+E)=1/(D/E+1)=1/1.6=0.625

proportion of debt=D/(D+E)=1/(1+1/(D/E))=1-proportion of equity=1-0.625=0.375

t=34%

cost of debt=4%

WACC under new capital structure=proportion of equity*cost of equity+proportion of debt*cost of debt*(1-tax rate)

=0.625*16.3696+0.375*4*(1-34%)

=11.221%

Generally, a stable or mature company's beta does not change much due to business risk. Hence, change in cost of equity due to business risk=0

Change in cost of equity due to market risk=16.3696-15.2=1.1696

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