Question: 1. (A) Johnson inc. has a capital structure consisting of $2 million debt and $8 million common equity. Johnsonís debt currently cost 7 percent. The risk-free rate is 4 percent, and the market risk premium is 6 percent. Johnson estimates that its cost of equity is currently 11 percent. The company has a 35 percent tax rate. Johnson is considering changing its capital structure to 45 percent debt and 55 percent equity. If the company went ahead with the proposed change, the cost of the company's debt would rise to 8 percent. The proposed change will have no effect on the company's tax rate.
(i) What is Johnsonís current WACC?
(ii) What is the current beta?
(ii (iii) What would Johnson beta be if the company had no debt.?
(i (iv) What would be the company's new cost of equity if it adopted the proposed change in capital structure?
(v (v) What would the company's new WACC be if it adopted the proposed change in capital structure?
(v (vi ) Based on your answer to part (v), would you advise Johnson to adopt the proposed change in capital structure? Explain.
(B) If Johnson currently pays a dividend of $1.50 per share and it will continue to pay this dividend into the future and this dividend will continue to grow at a constant rate of 7% per year, what is the current value of the stock? What is the value of the stock after recapitalization?
2. M 2. Magnificent Manes Hair Salons is forecasting a 17% increase in sales.
(a) (a) What would be its degree of operating leverage if it anticipates that its EBIT will go from $150,000 to $175,000 during the same time frame?
(b (b) What would be the degree of financial leverage if the companyís earnings before interest and taxes increased from $150,000 to $175,000 ? The firm had EPS of $1.25 but, with the increased earnings, it anticipates an EPS of $1.37.
(c) Wh (c) What is the degree of combine leverage?
(d)Wh (d) What are the implications of financial leverage? Edit
Answer: i) The Current WACC of Johnson's firm is calculated as under
Cost of Debt = Interest rate*(1-Tax rate) = 7*(1-.35) = 4.55%
Cost of Equity = 11%
Weight of Debt = 20%; Weight of Equity = 80%
WACC= Weight of Debt* Cost of Debt + Weight of Equity* Cost of Equity
= (20%*4.55%) + (80%*11%) = 9.71%
ii) Beta of the company can be calculated
By using CAPM formula, where ,
Cost of Equity (Ke) = Risk free Rate of return (Rf) + Beta *(Risk Premium (Rm)- Risk free Rate of Return)
By Putting the values of Ke, Rf and Rm in the above formula
Beta = 3.5 Edit
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