Please guide me where I went wrong?
Find the attached file and let me know where I went wrong?
Thanks
>2
Sheet
| Formulas | ||||||||||||||||
| Unlevered Beta | Levered Beta | Tax Rate | ||||||||||||||
| Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity))) | ||||||||||||||||
| Part 1) | ||||||||||||||||
| Current Firm Value | Debt Value + Equity Value (Unlevered Value) | |||||||||||||||
| Unlevered Value = | 9 | million | ||||||||||||||
| Add: BTc | 0.8 | |||||||||||||||
| Less: Combined cost | 0.1 | 4 | ||||||||||||||
| 9.66 | ||||||||||||||||
| Part 2) | ||||||||||||||||
| Optimal Capital Structure: | ||||||||||||||||
| It is the point or mix of | D/E | WACC | ||||||||||||||
| Current Beta (Levered) | 1. | 5 | ||||||||||||||
| Current Debt | ||||||||||||||||
| Current Equity | ||||||||||||||||
| E(Rm) | 14% | |||||||||||||||
| Rf | 2% | |||||||||||||||
| Debt Rate (at 2million) | 7% | |||||||||||||||
| 40% | ||||||||||||||||
| 1. | 3 | |||||||||||||||
| Amount of debt (in millions) | Amount of Equity (in millions) | Cost of Equity (Using CAPM) | Cost of debt | After tax cost of debt | Debt Weight | Equity Weight | ||||||||||
| 8.66 | 11.5% | 1.42 | 19.0% | 5.0% | 3.0% | 10.4% | 89.6% | 17.33% | ||||||||
| 7.66 | 26.1% | 1.53 | 20.4% | 7.0% | 4.2% | 20.7% | 79.3% | 17.02% | ||||||||
| 6.66 | 45.0% | 1.68 | 22.2% | 10.0% | 6.0% | 31.1% | 68.9% | 17.15% | ||||||||
| 5.66 | 70.7% | 1.88 | 24.6% | 14.0% | 8.4% | 41.4% | 58.6% | 17.90% | ||||||||
| 4.66 | 107.3% | 2.18 | 28.1% | 20.0% | 12.0% | 51.8% | 48.2% | 19.77% | ||||||||
| The Firm’s current capital structure is optimal, as its WACC is minimum at the current mix of Debt and Equity levels |
Hoi:
This is incorrect. You cannot add the debt value into the Vu to determine the VL. Instead, you should use the APV method provided by MM.
VL = Vu + BTc – Combined costs of financial distress and agency.
In this case, the combined costs of financial distress and agency is $0.14m because the current debt level is $2m and tax rate is 40% ($0.14=$2*0.07).
Using the APV method we can determine the current firm value and provide an answer to Q1.
Using the same method and the data provided in the problem we can also provide a quantitative answer to Q2. We do so by calculating the firm value at different levels of debts. At some levels of debts the comined costs will overshadow the tax benefit of debt, resulting in optimal leverage.
Hoi:
This is a difficult method to implement because shareholder risk and return will increase with debt usage. Also, firm value will change as well. There are too many variables to track when using this method. A more direct approach is one discussed in comment above. Use the APV method given by MM. Please give it a try.
Sheet1
Debt/Equity
WACC
WACC / Cost of Capital
