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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

RECAPITALIZATION Currently, Bloom Flowers Inc. has a capital structure consisting of 20% debt and 80% equity. Bloom’s debt currently has an 8% yield to maturity. The risk-free rate (rRF) is 5%, and the market risk premium (rM − rRF) is 6%. Using the CAPM, Bloom estimates that its cost of equity is currently 12 5%. The company has a 40% tax rate.

  1. a. What is Bloom’s current WACC?
  2. b. What is the current beta on Bloom’s common stock?
  3. c. What would Bloom’s beta be if the company had no debt in its capital structure? (That is, what is Bloom’s unlevered beta, bU?)

Bloom’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.

  1. d. What would be the company’s new cost of equity if it adopted the proposed change in capital structure?
  2. e. What would be the company’s new WACC if it adopted the proposed change in capital structure?
  3. f. Based on your answer to part e, would you advise Bloom to adopt the proposed change in capital structure? Explain.

a.

Summary Introduction

To identify: The current weighted average cost of capital.

Recapitalization:

Recapitalization is the process to change the capital structure such as equity and debt of the company as per the requirement.

Weighted Average Cost of Capital:

Weighted average cost of capital is based on capital structure of the company. It considers the portion of finances acquired through various sources.

Explanation

Given,

The equity is 80%.

The debt is 20%.

The cost of equity is 12.5%.

The interest on debt is 8%.

The tax rate is 40%.

Formula to calculate the WACC,

WACC=(Equity×Costofequity)+[Debt×Interestrate×(1Taxrate)]

Where,

  • WACC is weighted average cost of capital.

Substitute 80% for equity, 12.5% for cost of capital, 20% for debt, 8% for interest rate and 40% for tax rate

b.

Summary Introduction

To identify: The beta.

c.

Summary Introduction

Unlevered Beta:

The unlevered beta is also known as asset beat as to identify the volatility of return, the company doesn’t take into consideration of debt.

To identify: The unlevered beta of Company BF.

d.

Summary Introduction

To identify: The change in cost of equity due to change capital structure.

e.

Summary Introduction

To identify: The current weighted average cost of capital.

Weighted Average Cost of Capital:

Weighted average cost of capital is based on capital structure of the company. It considers the portion of finances acquired through various sources.

f.

Summary Introduction

To Explain: The company should adopt the change or not.

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