Final answer:
In preparation for a leveraged buyout, Safety Systems is intending to increase its debt-to-equity ratio to 0.80, which will affect its unlevered beta and the new beta after the buyout. The cost of equity capital is likely to rise due to increased financial risk, while the weighted average cost of capital may decrease if the cost of debt is lower. Firms might engage in such strategies for tax, return on equity, or management benefits.
Step-by-step explanation:
Understanding the Leveraged Buyout and its Impact on Beta
When Safety Systems is contemplating a leveraged buyout, this will involve increasing its level of debt relative to equity. Initially, the firm has $50 million in debt and $100 million in equity, resulting in a debt-to-equity ratio of 0.5. As the firm ponders adjusting the debt-to-equity ratio to 0.80, we must examine the implications on its unlevered beta and the new beta post-leverage buyout.
A) Calculating the Unlevered Beta
The unlevered beta is a measure of the risk of a firm's business, independent of its capital structure. It reflects the risk inherent to the firm’s operations without the effect of financial leverage. Given the original debt-to-equity ratio and the provided beta of the firm's stock (1.2), we can use the Hamada equation to calculate the unlevered beta.
B) Finding the New Beta after the Buyout
After increasing the firm's debt-to-equity ratio to 0.80, the new beta can be determined again using the Hamada equation, accounting for the increased financial risk due to higher levels of debt. The new beta is expected to be higher than the original beta, signifying greater risk to equity holders after the buyout.
C) Effects on Cost of Capital
Changes in debt levels can affect both the cost of equity capital and the weighted average cost of capital (WACC). With higher leverage, the cost of equity typically increases due to the increased risk perceived by equity investors. Conversely, the WACC could potentially decrease if the cost of debt is lower than the cost of equity and the tax shield benefits from interest payments are factored in.
Firms may pursue a leveraged buyout strategy to take advantage of tax benefits, improve return on equity, and facilitate management or ownership changes, among other reasons.