Lahore School of Economics

Financial Management II
Capital Structure and Leverage – 3
Assignment 17

Examples
1. Tool Manufacturing has an expected EBIT of $89,000 and a tax rate of 40%. The firm has $95,000 in outstanding debt
at an interest rate of 8.5%, and its current debt to equity ratio is 25%. The market price of Tool’s share is $2 and it has
190,000 common shares outstanding. The risk-free rate in the economy is 5% and market risk premium is estimated at 6%.
Tool Manufacturing’s beta at the moment is 1.2. The firm feels it can increase its share price in the market if it issues more
debt of $95,000 and uses the proceeds to repurchase its common stock from the market. However, Tool’s bond rating will
decline as a result of higher leverage, and its interest rate on all debt will rise to 10%. Calculate (1) the current WACC of
Tool, (2) the new WACC after recapitalization and (3) the market price of the common stock due to recapitalization.

2. Harley Motors has $10 million in assets, which were financed with $2 million of debt and $8 million in equity.
Harley’s beta is currently 1.2, and its tax rate is 40%. Use the Hamada equation to find Harley’s unlevered beta, bU.

Problems for Assignment

1. Currently, Bloom Flowers Inc. has a capital structure consisting of 20% debt and 80% equity. Bloom’s debt currently
has an 8% yield to maturity. The risk-free rate (rRF) is 5%, and the market risk premium (rM – rRF) is 6%. Using the
CAPM, Bloom estimates that its cost of equity is currently 12.5%. The company has a 40% tax rate.
a) What is Bloom’s current WACC?
b) What is the current beta on Bloom’s common stock?
c) What would Bloom’s beta be if the company had no debt in its capital structure? (That is, what is Bloom’s unlevered
beta, bU?)

Bloom’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 9.5%. 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 Bloom to adopt the proposed change in capital structure? Explain.

2. Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for $28.80 per set, and
this year’s sales are expected to be 450,000 units. Variable production costs for the expected sales under present production
methods are estimated at $10,200,000, and fixed production (operating) costs at present are $1,560,000. WCC has
$4,800,000 of debt outstanding at an interest rate of 8%. There are 240,000 shares of common stock outstanding, and there
is no preferred stock. WCC is in the 40% federal-plus-state tax bracket. The company is considering investing $7,200,000
in new equipment. Sales would not increase, but variable costs per unit would decline by 20%. Also, fixed operating costs
would increase from $1,560,000 to $1,800,000. WCC could raise the required capital by borrowing $7,200,000 at 10% or
by selling 240,000 additional shares at $30 per share. What would be WCC’s EPS
a) Under the old production process
b) Under the new process if it uses debt
c) Under the new process if it uses common stock?