Chapter 13 Capital Structure and Leverage 433RECAPITALIZATION 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.
BREAKEVEN AND LEVERAGE 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. The dividend
payout ratio is 70%, and 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.
a. What would be WCC’s EPS (1) under the old production process, (2) under the new
process if it uses debt, and (3) under the new process if it uses common stock?13-1113-11
13-1213-12
408012016020024028010 20 25 30 40 50 60Revenues and Costs
(Thousands of Dollars)Fixed CostsBreak-Even PointUnits (Thousands)Total Revenues Total CostsFirm A408012016020024028010 20 30 40 50 60Revenues and Costs
(Thousands of Dollars)Fixed CostsBreak-Even PointUnits (Thousands)Total Revenues Total CostsFirm B0 0Break-Even Charts for Problem 13-10