Chapter 15

Bickley Engineering Company has a capital structure of 30% Debt and 70% Equity. Its current Beta is 1.3, and its Market Risk Premium is 7.5% Points. The current Risk Free Rate is 3.5%. Bickley’s marginal tax rate is 40%.

What is the Unlevered Beta of Bickley?

Unlevered beta = levered beta/(1+(1-T) D/E) = 1.3 /(1+(1-0.4)X(0.3/0.7) = 1.03

Bickley’s management would like to change its capital structure to 15% Debt and 85% equity by retiring its bonds yielding 8%. The remaining long term debt will be at 7%. The marginal tax rate will remain the same.

What will be Bickley’s new Beta with this new 15/85 capital structure?

New beta = 1.03 X (1+ (1-0.4) X 0.15/0.85 = 1.14

What is the WACC (Weighted Average Cost of Capital) of Bickely with its 30/70 capital structure? Bickley’s average borrowing rate with this capital structure is 7.5%.

WACC = Proportion of debt X after tax cost of debt + Proportion of equity X cost of equity

Using CAPM

Cost of equity = Rf + (Rm-Rf) beta = 3.5% + 7.5% X 1.3 = 13.25%

WACC = 0.3 X 7.5% X (1-0.4) + 0.7 X 13.25% = 10.625%

What will be Bickley’s WACC with its 15/85 capital structure?

Cost of equity = 3.5% + 7.5% X 1.14 = 12.05%

WACC = 0.15 X 7% X (1-0.4) + 0.85 X 12.05% = 10.87%

Chapter 26

Yancey Industries' Free Cash Flow for the past 12 months is $2.0 Million, and the future expected growth rate of this FCF is 6.5%. Yancey has no debt in its current capital structure. Its Cost of Equity is 11.5%. Its tax rate is 35%.

Calculate the Unlevered Value of Yancey (Vu).

Unlevered value = FCF 1/(Cost of equity - growth rate)

FCF 1 = FCF 0 X (1+g) = 2.0 X 1.065

Unlevered value = 2.0 X 1.065/(11.5% - 6.5%) = $42.6 million

Calculate VL and rsL for the scenario whereby Yancey uses $8.0 Million Debt costing 8%.

VL = Vu + (rdTD/rsU - g)

= 42.6 + (8% X 35%X8/(11.5%-6.5%)

= $47.08 million rsL = rsU + (rsU - rd) D/S

Value of debt D = 8 million

Value of equity S = 47.08 -8 = 39.08 rsL =