Question

Under the assumptions of Modigliani and Miller's original paper, a firm's stock price will be maximized at 100% Signaling theory implies that a firm with extremely favorable prospects will be more likely to issue to fund any new projects. When a firm announces a new stock offering, the price of its stock will usually . When information is , managers have more information about a firm's prospects than investors do. Blue Ram Brewing Company currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity. The firm's unlevered beta is 1.25, and its cost of equity is 11.75%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 11.75%. The risk-free rate of interest (TRF) is 3%, and the market risk premium (RP) is 7%. Blue Ram's marginal tax rate is 40%. Blue Ram is examining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information that follows to analyze its weighted average cost of capital (WACC). Complete the following table. E/Cap Ratio 1.0 Bond Rating Before-Tax Cost of Debt (ra) D/Cap Ratio 0.0 0.2 0.4 0.6 0.8 D/E Ratio 0.00 0.25 0.67 1.50 Cost of Equity (rs) 11.75% 13.08% 15.25% 0.8 Levered Beta (b) 1.25 - 1.75 2.38 4.25 WACC 11.75% 11.44% 0.6 0.4 0.2 8.1% 8.5% 10.9% 13.9% BBB BB C 11.79% 32.75%

Answer 1

Answer a.

Under the assumptions of Modigliani and Miller’s original paper, a firm’s stock price will be maximized at 100% debt. Signaling theory implies that a firm with extremely favorable prospects will be more likely to issue stock to fund any new projects. When a firm announces a new stock offering, the price of its stock will usually decrease. When information is asymmetric, managers have more information about a firm’s prospects than investors do.

Answer b.

Case A:

Levered Beta = Unlevered Beta * [1 + (1 - tax) * (D/E Ratio)]
Levered Beta = 1.25 * [1 + (1 - 0.40) * 0.25]
Levered Beta = 1.25 * 1.15
Levered Beta = 1.44

Case B:

WACC = (D/Cap Ratio) * Before-tax Cost of Debt * (1 - tax) + (E/Cap Ratio) * Cost of Equity
WACC = 0.40 * 8.50% * (1 - 0.40) + 0.60 * 15.25%
WACC = 11.19%

Case C:

Cost of Equity = Risk-free Rate + Levered Beta * Market Risk Premium
Cost of Equity = 3.00% + 2.38 * 7.00%
Cost of Equity = 19.66%

Case D:

D/E Ratio = (D/Cap Ratio) / (E/Cap Ratio)
D/E Ratio = 0.80 / 0.20
D/E Ratio = 4.00

WACC = (D/Cap Ratio) * Before-tax Cost of Debt * (1 - tax) + (E/Cap Ratio) * Cost of Equity
WACC = 0.80 * 13.90% * (1 - 0.40) + 0.20 * 32.75%
WACC = 13.22%