2. BEA is considering a change it its capital structure. BEA currently has $20 m
ID: 2798186 • Letter: 2
Question
2. BEA is considering a change it 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 faces a 40% 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. BEA has a current cost of equity of 9%.
a. What is BEA’s current levered beta?
b. What is BEA’s unlevered beta?
c. What would be BEA’s estimated cost of equity if it were to change its capital structure to 40 percent debt and 60 percent equity?
Explanation / Answer
Levered beta = Unlevered beta [1+ (1-t) (Debt/Equity)]
Cost of Equity (Ke) = Rf + Levered Beta * (Mr - Rf)
=> 9 = 6 + Beta * 4 => Levered Beta = 0.75
Levered beta = Unlevered beta [1+ (1-t) (Debt/Equity)]
=> 0.75 = Unlevered Beta [ 1+ (1-0.4)(20/80)]
=> 0.75 = Unlevered Beta*1.15
=> Unlevered Beta = 0.75/1.15 = 0.652
Therefore, Current levered Beta = 0.75
Unlevered Beta = 0.652
c) Levered beta = Unlevered beta [1+ (1-t) (Debt/Equity)]
= 0.652 [1+(1-0.4)(40/60)] = 0.913
Therefore, Ke = 6 + 0.913*4 = 9.6512.
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