Question

Currently, Forever Flowers Inc. has a capital structure consisting of 35% debt and 65% equity. Forever's debt currently has an 8% yield to maturity. The risk-free rate (TRF) is 5%, and the market risk premium (CM - PRP) is 8%. Using the CAPM, Forever estimates that its cost of equity is currently 13%. The company has a 40% tax rate. The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the questions below. Do not round intermediate calculations. Open spreadsheet a. What is Forever's current WACC? Round your answer to two decimal places. % b. What is the current beta on Forever's common stock? Round your answer to two decimal places. c. What would Forever's beta be if the company had no debt in its capital structure? (That is, what is Forever's unlevered beta, bu?) Round your answer to two decimal places. Forever's financial staff is considering changing its capital structure to 40% debt and 60% equity. If the company went ahead with the proposed change, the yield to maturity on the company's bonds would rise to 9.5%. 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? 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? Round your answer to two decimal places. % f. Based on your answer to part e, would you advise Forever to adopt the proposed change in capital structure?

Answer 1

Please refer to below spreadsheet for calculation and answer. Cell reference also provided.

B C 3 % debt in capital stucture,wd 4 % common equity in capital stucture, wc 5 Yield to maturity on debt, rd 6 Risk free rate 7 Market risk premium 8 Cost of common equity 9 Tax rate 10 11 % debt in new capital stucture,wd new 12 % common equity in new capital stucture,wc new 13 Changed yield to maturity, rd new 35.00% 65.00% 8.00% 5.00% 8.00% 13.00% 40.00% 40.00% 60.00% 9.50% Formulas 14 15 10.13% =B3*85*(1-B9)+B4*B8 16 WACC 17 18 1.00 =(B8-B6)/B7 0.76 =B19/(1+(1-B9)*(B3/B4)) 19 Levered beta 20 21 22 Unlevered beta, bu 23 24 Cost of equity calculation with change capital structure 25 Levered beta 26 Cost of equity with new capital struture, rs new 27 1.06 13.47% =B22*(1+(1-B9)*(B11/B12)) =B6+B7*B25 28 10.36% =B11*B13*(1-B9)+B12*B26 29 WACC, new 30 31 Recommendation on capital structure 32 Do Not Change #N/A 33

Cell reference -

0.35 0.65 0.08 0.05 0.08 0.13 0.4 3 % debt in capital stucture,wd 4 % common equity in capital stucture,wc 5 Yield to maturity on debt, rd 6 Risk free rate 7 Market risk premium 8 Cost of common equity 9 Tax rate 10 11 % debt in new capital stucture, wd new 12 % common equity in new capital stucture, wc new 13 Changed yield to maturity, rd new 14 15 16 WACC 0.4 0.6 0.095 Formulas =B3*B5*(1-B9)+B4*B8 =FORMULATEXT(316) 17 =(B8-B6/B7 =FORMULATEXT(B19) =B19/(1+(1-B9)*(B3/B4)) =FORMULATEXT(B22) 18 19 Levered beta 20 21 22 Unlevered beta, bu 23 24 Cost of equity calculation with change capital structure 25 Levered beta 26 Cost of equity with new capital struture, rs new 27 28 29 WACC, new 30 31 Recommendation on capital structure 32 33 =B22*(1+(1-B9)*(B11/B12) =B6+B7*B25 =FORMULATEXT(B25) =FORMULATEXT(B26) =B11*B13*(1-B9)+B12*B26 =FORMULATEXTB29) Do Not Change =FORMULATEXT(B31)

Hope this will help, please do comment if you need any further explanation. Your feedback would be highly appreciated.