Capital structure practice solution(1)

5 is the levered beta at the de ratio of 025 200m

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The stock beta of 1.5 is the levered beta at the D/E ratio of 0.25 ($200m/ $800m). Using the levered beta formula, the unlevered beta can be calculated as 1.277 d) What will be the levered betas at the debt ratio of 20%, 30%, and 40%? Calculate the corresponding cost of equity using CAPM. (5 points) Using the unlevered beta calculated above and the levered beta formula, we can calculate @20% debt ratio, the levered beta is 1.5; @30% debt ratio, the levered beta is 1.66; @40% debt ratio, the levered beta is 1.87. Using the CAPM formula, we can calculate the cost of equity @20 debt ratio, Ke = 11.5%; @30 debt ratio, Ke = 12.3%; @40 debt ratio, Ke = 13.35%; e) Calculate the WACC under the three debt ratios? Which debt ratio will you choose to maximize firm value? (5 points) Use the WACC formula (there is no preferred stock here) @20% debt ratio, WACC = 0.2*4.30%*(1-0.3) + 0.8*11.5% = 9.80% @30% debt ratio, WACC = 0.3*4.63%*(1-0.3) + 0.7*12.3% = 9.58% @40% debt ratio, WACC = 0.4*4.84%*(1-0.3) + 0.6*13.35% = 9.37% Therefore, we should choose the 40% debt ratio to maximize firm value.
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