5.
Currently, Bloom Flowers Inc. has a capital structure consisting
of 20 percent debt and 80 percent equity. Bloom’s debt currently has an 8
percent yield to maturity. The risk-free rate, rRF,
is 5 percent, and the market risk premium, (rM-rRF),
is 6 percent. Using the CAPM, Bloom estimates that its cost of equity is
currently 12.5 percent. The company has a 40 percent 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 percent debt and 60 percent
equity. If the company went ahead with the proposed change, the yield to
maturity on the company’s bonds would rise to 9.5 percent. 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.
Would you advise Bloom to adopt the proposed change in capital structure?
Explain.
