Question

Recapitalization Currently, Forever Flowers Inc. has a capital structure consisting of 25% debt and 75% equity. Forever’s debt currently has a 7% yield to maturity. The risk-free rate is 6% and the market risk premium is 7%. Using the CAPM, Forever estimates that its cost of equity is currently 14.5%. The company has a 40% tax rate. What is Forever’s current WACC? What is the current beta on Forever’s common stock? What would Forever’s beta be if the company had no debt in its capital structure?

Answer 1

Answer:

WACC is 11.93%

The current Beta on common stock is 1.21

Beta without debt is 1.01

Explanation:

The formula for WACC is given as:

(E/V * Ke) + (D/V) * Kd * (1 – Tax rate)

E is  equity=75%

V is equity plus debt 100%

D debt 25%

Kd is cost of debt 7%

Ke is cost of equity is 14.5%

WACC=(75%/100%)*14.5%+(25%/100%)*(7%)*(1-0.40)

WACC=0.11925

WACC=11.93%

Using the capital asset pricing model formula,beta can be computed

R(E)=Rf+Beta(Risk premium)

R(E) is expected return =14,5%

Rf is risk free rate=6%

Risk premium=7%

Beta is unknown,assume it is x

14.5%=6%+x(7%)

14.5%-6%=x(7%)

x(7%)=8.5%

x=8.5%/7%

x=1.21

Beta when no debt exists

Unlevered Beta = Levered Beta/1+((1-tax rate)*Debt/equity)

                           =1.21/(1+(1-0.4)*25%/75%

                            =1.01