eztomheducationcomhmtpx Macbeth Spot Removers is entirely eq

ezto.mheducation.com/hm.tpx Macbeth Spot Removers is entirely equity fninanced. Use the following information Number of shares Price per share Market value of shares Expected operating income Return on assets 1,000 $10 $10,000 $1,500 15% Macbeth now decides to issue $5,000 of debt and to use the proceeds to repurchase stock. Suppose that Ms. Macbeth\'s investment bankers have informed her that since the new issue ot debt is risky, debtholders will demand a return of 12.5%, which is 25% above the risk-free interest rate a. What are ra and re after the debt issue? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.) Retum on assets Return on equity 96 b. Suppose that the beta of the unevered stock was 6. What will ?? ?-, and ?? be after the change to the capital structure? (Do not round intermediate calculations. Round your answers to 1 decimal place.) Asset beta Debt beta Equity beta Type here to search

Solution

(a) Operating Income = $ 1500, As the firm is entirely equity financed and there is no mention of a tax rate(therefore assumed to be zero), the operating income can be reliably assumed to be equal to the firm\'s net income.

Therefore, Net Income = $ 1500

Market Value of Share = $ 10000 = Total Asset Value (as the firm is entirely equity financed)

The firm issues debt worth $ 5000 to repurchase stock and introduce debt into the capital structure, thereby ensuring a debt to equity ratio of 1 and a debt to capital ratio of 0.5. Further, the absence of tax means that no additional value is created by the introduction of debt and the asset value continues being $10000.

Interest Rate on Debt = 12.5 %

Interest Expense = 0.125 x 5000 = $ 625

Net Income = Operating Income - Interest Expense = 1500 - 625 = $ 875

Return on Asset = Net Income / Asset Value = 875 / 10000 = 0.0875 or 8.75%

Return on Equity = Net Income / Equity Value = 875 / 5000 = 0.175 or 17.5 %

(b) Unlevered Beta = 0.6

Unlevered Beta is the beta of an all equity financed firm which essentially implies that this beta value captures only the firm\'s business risk (risk of firm\'s asset) and not the financial risk (as financial leverage is absent). Hence, the unlevered beta is the firm\'s asset beta.

Asset Beta = 0.6

Equity Beta = Asset Beta x [1+ Debt to Equity Ratio] = 0.6 x [1+1] = 1.2

Let the Debt beta be Bd

Therefore, Bd x (Debt/ Asset) + 1.2 x (Equity/Asset) = 0.6

Bd = 0