Problem:
Brown Inc. is considering changing its capital structure. Brown currently has $100 million in debt that carries a 6% interest rate. Its stock currently sells for $25 a share and there are 20 million shares outstanding. Brown is a zero growth firm and pays out all its earnings as dividends. Brown's EBIT is $20 million and the tax rate is 35%. The risk free rate is 3% and the market risk premium is 5%. Brown is considering increasing its debt to 40% and buying back stock with the money it raises. New debt could be sold for 8%. Brown's beta is currently 1.2.
Required:
Question 1: What is Brown's unlevered beta?
Question 2: What will the beta and the cost of equity be after the recapitalization?
Question 3: What is the WACC before and after the capital structure change. Should Brown increase their debt to 40%?
Note: Be sure to show how you arrived at your answer.