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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

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 (rRF) is 6%and the market risk premium (rM–rRF) is 7%. Using the CAPM, Forever estimates that its cost of equity is currently 14.5%. The company has a 40% tax rate.

a. What is Forever’s current WACC?

b. What is the current beta on Forever’s common stock?

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, buy?

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 10.5%. 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?

e. What would be the company's new WACC if it adopted the proposed change in capital structure?

f. Based on your answer to part e, would you advise Forever to adopt the proposed change in capital structure? Explain.

a.

Summary Introduction

To identify: The current weighted average cost of capital.

Introduction:

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 the capital structure of the company. It considers the portion of finances acquired from various sources.

Explanation

The items required for the calculation of WACC are equity, cost of equity, debt, interest on debt and tax rate.

Given,

The equity is 75%.

The debt is 25%.

The cost of equity is 14.5%.

The interest on debt is 7%.

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 75% for equity, 14.5% for cost of capital, 25% for debt, 7% for interest rate and 40% for tax rate,

WACC=(0

b.

Summary Introduction

To identify: The current beta on common stock.

c.

Summary Introduction

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.

f.

Summary Introduction

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

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