Question

If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. Bernie’s is in the 25 percent state-plus-federal corporate tax bracket, its unlevered beta is .98, the risk-free rate is 2.5 percent, and the market risk premium is 8.5 percent.

The company’s EBIT was $300 million last year and is expected to grow at a rate of 3% per year forever. The firm is currently financed with all equity and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firm’s owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm’s investment banker the following estimated costs of debt for the firm at different capital structures:

% Debt	rd
0%
10%	7.00%
20%	7.50%
30%	9.00%
40%	11.75%

7.   For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC.

8.   Now calculate the corporate value for each capital structure. Also, calculate the value of the debt and equity of the firm.

Answer 1

7. Calculate the Levered beta, the cost of equity and the WACC as follows:

Debt %	Rd	Equity	Beta (1)	Cost of equity (Re) (2)	WACC (3)
0%		100%	0.98	10.83%	10.83%
10%	7%	90%	1.06	11.51%	10.88%
20%	7.50%	80%	1.16	12.36%	11.01%
30%	9.00%	70%	1.30	13.55%	11.51%
40%	11.75%	60%	1.47	15.00%	12.53%

Working notes:

1. The beta of the stock is calculated using the following formula:

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2. The cost of Equity is calculated using the following formula:

3.The WACC is calculated using the following formula:

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8. Calculate the corporate value of each capital structure as follows:

Value of equity and debt are calculated as proportionate values multiplied by the corporate value.

WACC	FCF	Corporate value	Value of Equity	Value of debt
10.83%	225,000,000	24,367,500	24,367,500	0
10.88%	225,000,000	24,489,000	22,040,100	2,448,900
11.01%	225,000,000	24,779,250	19,823,400	4,955,850
11.51%	225,000,000	25,897,500	18,128,250	7,769,250
12.53%	225,000,000	28,181,250	16,908,750	11,272,500