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%*(10.3) + 0.8*11.5% = 9.80%
@30% debt ratio, WACC = 0.3*4.63%*(10.3) + 0.7*12.3% = 9.58%
@40% debt ratio, WACC = 0.4*4.84%*(10.3) + 0.6*13.35% = 9.37%
Therefore, we should choose the 40% debt ratio to maximize firm value.
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 Fall '09
 SA'EED
 Debt, Weighted average cost of capital, Credit rating, EBIT coverage ratio

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