FM II Assignment 17 Solution 19
FM II Assignment 17 Solution 19
Financial Management II
Capital Structure and Leverage – 3
Assignment 17 Solution
Problems for Assignment
Q1) a. WACC = wdrd(1 – T) + wcrs
= (0.2)(8%)(1 – 0.4) + (0.8)(12.5%)
= 10.96%.
b. The firm's current levered beta at 20% debt can be found using the CAPM formula.
rs = rRF + (rM – rRF)b
12.5% = 5% + (6%)b
b = 1.25.
e. The relevant before-tax cost of debt is now 9.5% and the cost of equity is 14.13%.
WACC = wdrd(1 – T) + wcrs
= (0.4)(9.5%)(1 – 0.4) + (0.6)(14.13%)
= 10.76%.
f. The firm should be advised to proceed with the recapitalization as it causes the WACC to decrease
from 10.96% to 10.76%. As a result, the recapitalization would lead to an increase in firm value.
EPS should improve, but expected EPS is significantly higher if financial leverage is used.
Examples
Q1) a) Market value of equity = Market price of share x Number of shares outstanding
= $2 x 190,000
= $380,000
Debt = $95,000
Total Assets = 95,000 + 380,000 = $475,000
rs = Rrf + RPM*b
= 5% + 6%*1.2
= 12.2%
b) WACC will change after recapitalization due to change in weights as well as cost of capital.
New rd = 10%
To calculate new rs, the new levered beta is needed.
To calculate the new levered beta, the unlevered beta has to be calculated first at existing D/E using Hamada’s
equation.
bL = bU[1 + (1 – T)(D/E)]
1.2 = bU[1 + (1 – 0.4)(95000/380000)]
1.2 = bU(1.15)
bU = 1.04347.
c) The market price of the share will also change after recapitalization.
As growth rate is 0%, EPS = D1
Q2) From the Hamada equation, b = bU[1 + (1 – T)(D/E)], we can calculate bU as bU = b/[1 + (1 – T)(D/E)].
bU = 1.2/[1 + (1 – 0.4)($2,000,000/$8,000,000)]
bU = 1.2/[1 + 0.15]
bU = 1.0435.