Additional practice problems for Midterm
1. Jewell Systems is a firm that manufactures computer furniture and software. It derives 70% of its value
from the software business and 30% from its furniture business. The firm has equity with a market value
of $ 600 million and debt with a market value of $ 400 million. The firm has a levered beta of 1.30. The
firm is considering divesting its furniture business and repaying debt with the cash from the divestiture.
(The tax rate is 40%)
a. If the furniture business has an unlevered beta of 0.80, estimate the unlevered beta for Jewell
Systems after the divestiture.
b. Estimate the levered beta for Jewell after the divestiture and the repayment of the debt.
c. How would your answer to (b) change if you were told that half the money would be used to
buy back stock and the other half used to repay debt?
a. Current levered beta =
1.30
Unlevered beta for firm before divestiture = 1.3/(1+(1-.4)(400/600)) =
0.9286
0.9286 = Software beta (0.70) + 0.80 (0.30)
Unlevered beta for software = (0.9286 - 0.24)/0.70 =
0.9837
! This will be the unlevered beta after divestiture
Debt after divestiture = 400 - 300 =
100
b. New levered beta = 0.9837 (1 + (1-.4) (100/600)) =
1.0821
c. If half had been used to buy back stock,
new Levered beta = 0.9837 (1 + (1-.4)(250/450)) =
1.3116
2. LT&T, a telecommunica�ons firm, reported earnings before interest and taxes of $ 2 billion and
interest expenses of $ 400 million. The book value of debt at the end of the year was $ 6 billion, and the
average maturity of the debt is 8 years. The firm has 250 million shares outstanding, trading at $ 40 a
share. The table below summarizes the rela�onship between interest coverage ra�os and ra�ngs for
large U.S. firms.
Interest Coverage Ratio
Rating
Default Spread
> 12.5
AAA
0.20%
9.50 - 12.50
AA
0.50%
7.50 – 9.50
A+
0.80%
6.00 – 7.50
A
1.00%
4.50 – 6.00
A-
1.25%
