Question

The following data pertains to Zonk Corp., a manufacturer of ball bearings (dollar amounts in millions):

Total assets: $7,460
Interest-bearing debt: $3,652
Average pre-tax borrowing cost: 10.5%
Common equity: Book value $2,950, Market value $13,685
Income tax rate: 35%
Market equity beta: 1.10
Assume that Zonk is a potential leveraged buyout candidate. Assume that the buyer intends to put in place a capital structure that has 80 percent debt with a pretax borrowing cost of 14 percent and 20 percent common equity. Compute the revised equity beta for Zonk based on the new capital structure.

Options:

a) 7.26

b) 9.10

c) 7.70

d) 6.60

Answer 1

To compute the revised equity beta for Zonk Corp., the levered beta formula is used that incorporates the new debt-to-equity ratio, tax rate, and the given market equity beta. However, the calculated result does not match any of the provided options, indicating there might be an error in the variables or the calculation process.

Step-by-step explanation:

To compute the revised equity beta for Zonk Corp. based on the new capital structure, we need to use the levered beta formula which takes into account the new debt-to-equity ratio (D/E) and the income tax rate (T). The unlevered beta (asset beta) is adjusted for the financial leverage. The formula to adjust the beta is βL = βU * (1 + ((1 - T) * (D/E))), where βL is the levered beta (equity beta), βU is the unlevered beta (asset beta), T is the tax rate, D is the value of debt, and E is the value of equity.

In Zonk Corp.'s case, the market equity beta (which is similar to the levered beta) is 1.10. With an 80 to 20 debt-to-equity ratio, the proportion of debt is 4 times the equity (80% / 20%). Assuming the income tax rate remains at 35%, we can calculate the revised equity beta as follows:

βL (revised) = 1.10 * (1 + (1 - 0.35) * (4)) = 1.10 * (1 + (0.65) * (4)) = 1.10 * 3.60 = 3.96

However, since none of the options match the calculated result, and this calculation is complex and involves several steps, there may have been an error in the consideration of the components of the capital structure or any provided variables. Therefore, we are unable to provide a definitive answer from the options given.