Vegan Foods Inc has a current capital structure of 30% debt, 70% equit

Vegan Foods Inc has a current capital structure of 30% debt, 70% equity, and are in a 40% tax bracket. However, after speaking with their investment bankers they have decided to increase their debt to 40% of total capital.

Some of the firm’s managers are concerned that there may an increase in risk for stockholders due to the increased financial obligations resulting from the increased debt load. Currently, the levered beta for the firm is 1.20.

Use your knowledge of levered and unlevered betas to estimate the new levered beta for existing shareholders.

ANSWER

To begin we will use the equation βU =βL/[1+(D/E)(1-t)] where βU =1.20/[1+(.30/.70)(1-.40)] = 0.9545. The unlevered beta represents the riskiness of the existing assets without regard to how they are financed. With this information we can estimate the value of the levered beta assuming the new capital structure. Here, βL =[1+ (D/E)(1-t)] * βU βL =[1+ (.40/.60)(1-.40)] *0.9545 = 1.336.