Question

Quantitative Problem: Currently, Meyers Manufacturing Enterprises (MME) has a capital structure consisting of 35% debt and 65% equity. MME's debt currently has a 7.4% yield to maturity. The risk-free rate (TRF) is 5.4%, and the market risk premium (rM - PRF) is 6.4%. Using the CAPM, MME estimates that its cost of equity is currently 11.9%. The company has a 40% tax rate. a. What is MME's current WACC? Do not round intermediate calculations. Round your answer to two decimal places. b. What is the current beta on MME's common stock? Do not round intermediate calculations. Round your answer to four decimal places. c. What would MME's beta be if the company had no debt in its capital structure? (That is, what is MME's unlevered beta, bu?) Do not round intermediate calculations. Round your answer to four decimal places. MME's financial staff is considering changing its capital structure to 45% debt and 55% equity. If the company went ahead with the proposed change, the yield to maturity on the company's bonds would rise to 7.9%. 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? Do not round intermediate calculations. Round your answer to two decimal places. f. Based on your answer to Part e, would you advise MME to adopt the proposed change in capital structure? -Select-

Answer 1

Answer

1 Calculation of cost of debt

=Interest rate*(1-Tax Rate)

=7.4*(1-0.40)

= 4.44%

a. Calculation of current WACC of MME

Sr. No.	Sources	Weight	Cost	Weight*cost
a	Debt	0.35	4.44%	1.55%
b	Equity	0.65	11.90%	7.34%
	WACC			9.29%

b.Calculation of equity beta of MME

Ke= Rf+Beta*Market risk premium

11.90= 5.40+Beta*6.40

11.90-5.40= Beta*6.40

6.50 = Beta*6.40

Beta= 6.50/6.40

Beta = 1.0156

Where,

Rf= Risk free rate,

Ke= cost of equity

c. Calculation of beta of company if no debt in capital structure

Beta of equity = beta of company

beta of company = 1.0156

d. Calculation of revised cost of equity and debt due to change in capital structure

i)Cost of equity is same i.e. 11.90%

ii) Cost of debt = Interest*(1-Tax rate)

7.90*(1-40)

Revised cost of debt = 4.74%

e WACC of revised capital structure

Sr. No.	Sources	Weight	Cost	Weight*cost
a	Debt	0.45	4.74%	2.13%
b	Equity	0.55	11.90%	6.55%
	WACC			8.68%

f.Advise- Based on above calculation it is advisable to MME to adopot proposed change in capital structure.Due to proposd change MME will be reduced it's WACC by 0.61% (9.29-8.68)