Question

Globex Corp. is an all-equity firm, and it has a beta of 1. It is considering changing its capital structure to 65% equity and 35% debt. The firm's cost of debt will be 10%, and it will face a tax rate of 25%. What will Globex Corp's beta be if it decides to make this change in its capital structure? Now consider the case of another company: US Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 10%, and its tax rate is 25%. It currently has a levered beta of 1.25. The risk-free rate is 2.5%, and the risk premium on the market is 7%. US Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity. Increasing the firm's level of debt will cause its before-tax cost of debt to increase to 12%. First, solve for US Robotics Inc.'s unlevered beta. Use US Robotics Inc.'s unlevered beta to solve for the firm's levered beta with the new capital structure. Use US Robotics Inc.'s levered beta under the new capital structure, to solve for its cost of equity under the new capital structure. What will the firm's weighted average cost of capital (WACC) be if it makes this change in its capital structure? 12.10% 9.07% 7.26% 8.47%

Globex Corp. is an all-equity firm, and it has a beta of 1. It is considering changing its capital structure to 65% equity and 35% debt. The firm’s cost of debt will be 10%, and it will face a tax rate of 25%.

What will Globex Corp.’s beta be if it decides to make this change in its capital structure?

a)1.40

b)1.47

c)1.26

d)1.54

US Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 10%, and its tax rate is 25%. It currently has a levered beta of 1.25. The risk-free rate is 2.5%, and the risk premium on the market is 7%. US Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity. Increasing the firm’s level of debt will cause its before-tax cost of debt to increase to 12%.

First, solve for US Robotics Inc.’s unlevered beta

Use US Robotics Inc.’s unlevered beta to solve for the firm’s levered beta with the new capital structure.

Use US Robotics Inc.’s levered beta under the new capital structure, to solve for its cost of equity under the new capital structure.

What will the firm’s weighted average cost of capital (WACC) be if it makes this change in its capital structure?

Sorry for the blurry picture and thank you.

Answer 1

Unlevered beta (or asset beta) measures the market risk of the company without the impact of debt.

Unlevered beta = Levered beta / ( 1 +(1 - tax rate) * Debt / Equity)

Hence, Levered beta = Unlevered beta * ( 1 +(1 - tax rate) * Debt / Equity)

According to the problem, Unlevered beta of Globex Corp = 1.0

The company is planning to change its capital structure to 65% equity and 35% debt

Hence, Debt / Equity = 35/65

Tax Rate = 25%

Hence, Levered Beta = 1.0 * ( 1 + (1-0.25) * 35/65)

= 1.40

Hence, Globex Corp.’s beta be if it decides to make this change in its capital structure = 1.40

Correct Answer is Option A