Question

Safecorp currently has £500 million in debt and the market value of its equity is £800 million. Beta of its stock is 1.20. The company is planning a leveraged buyout (LBO) that will increase its debt-to-equity ratio to 5. If the marginal tax rate is 20%, what will be the equity beta of the firm after the LBO? (5 marks) 3. Beta plc is in steady state and has book value of equity of £500m. Its return on equity is 10%, cost of equity is 8%, and the payout ratio is 60%. b. What is the value of equity of the company? (3 marks)

Answer 1

Q2)

Unlevered Beta = Equity Beta / (1+(Debt / Equity)*(1 - Tax rate))

Unlevered Beta = 1.2 / (1+((500 / 800)*(1 - 20%)))

Unlevered Beta = 0.80

Levered Beta = Unlevered Beta * [1 + (1 – Tax Rate) * (Debt / Equity)]

Levered Beta = 0.80 * [1 + (1 - 20%) * (5)]

Levered Beta = 4

Equity Beta after the LBO = 4

Q3)

ROE = 10%

Dividend pay-out ratio = 60%

Retention ratio = 1 - Dividend pay-out ratio

Retention ratio = 40%

Expected steady state growth rate = ROE * Retention ratio

Expected steady state growth rate = 10% * 40%

Expected steady state growth rate = 4%

ROE = Net income / Book value

Net income = ROE * Book value

Net income = 10%*5000

Net income = 500

Dividend = 500*60%

Dividend = 300

Using DDM

Equity = Dividend * (1 + growth rate) / (Cost of equity - growth rate)

Equity = (300 * (1 + 4%)) / (8% - 4%)

Equity = 7800