RECAPITALIZATION Currently, Forever Flowers Inc. has a capital structure consist

Question

RECAPITALIZATION Currently, Forever Flowers Inc. has a capital structure consisting of 30% debt and 70% equity. Forever's debt currently has an 7% yield to maturity. The risk-free rate (TRF) is 496, and the market risk premium (rM-TRF) is 6%. Using the CAPM, Forever estimates that its cost of equity is currently 11.5%. The company has a 40% tax rate. a. What is Forever's current WACC? Round your answer to two decimal places. b. What is the current beta on Forever's common stock? Round your answer to two decimal places. c. What would Forever's beta be if the company had no debt in its capital structure? (That is, what is Forever's unlevered beta, bu?) Do not round intermediate calculations. Round your answer to two decimal places. Forever's financial staff is considering changing its capital structure to 40% debt and 60% equity. If the company went ahead with the proposed change, the yield to maturity on the company's bonds would rise to 10%. The proposed change will have no effect on the company's tax rate. d. What would be the company's new cost of equity if it adopted the proposed change in capital structure? Do not round intermediate calculations. Round your answer to two decimal places e. What would be the company's new WACC if it adopted the proposed change in capital structure? Round your answer to two decimal places. nanswer to part e, would you advise Forever to adopt the proposed change in capital structure? Select- Yes No

Explanation / Answer

We know that

WACC = rD (1- Tc )*( D / V )+ rE *( E / V )

here, rD is cost of debt

Tc is tax rate

D is debt value

E is equity value

rE is cost of equity

so WACC = .3*.07*(1-.4) + .7*.115 = 0.0931 or 9.31 %

using CAPM model, cost of equity = risk free rate + beta *(risk premium)

.115 = .04 + beta*(.06)

so beta = 1.25

Unlevered beta = levered beta /(1+(1-tax)*d/e)

= 1.25/(1+(0.6*.3/.7)) = 0.99

Now capital structure changed to debt 40% and equity 60%

so levered beta = 0.99 * (1+(1-.4)*.4/.6) = 1.386

so cost of equity = .04 + 1.386*.06 = 0.1231

new wacc = .1*.4*(1-.4) + .12*.6 = .096 or 9.6%

As the WACC has increased so we would not recommend to adopt proposed change

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