Question

Hula Enterprises is considering a new project to produce solar water heaters. The finance manager wishes to find an appropriate risk adjusted discount rate for the project. The (equity) beta of Hot Water, a firm currently producing solar water heaters, is 1. Hot Water has a debt to total value ratio of 0.3. The expected return on the market is 0.1, and the riskfree rate is 0.03. Suppose the corporate tax rate is 34 percent. Assume that debt is riskless throughout this problem. (Round your answers to 2 decimal places. (e.g., 0.16))

a. The expected return on the unlevered equity (return on asset, R0) for the solar water heater project is ______________%.

b. If Hula is an equity financed firm, the weighted average cost of capital for the project is __________%.

c. If Hula has a debt to equity ratio of 2, the weighted average cost of capital for the project is __________%.

d. The finance manager believes that the solar water heater project can support 20 cents of debt for every dollar of asset value, i.e., the debt capacity is 20 cents for every dollar of asset value. Hence she is not sure that the debt to equity ratio of 2 used in the weighted average cost of capital calculation is valid. Based on her belief, the appropriate debt ratio to use is __________%. The weighted average cost of capital that you will arrive at with this capital structure is __________%.

Answer 1

a. The unlevered cost of equity= 0.03 + 1*(0.1-0.03) = 0.1 or 10%

b. Given, the debt to total value ratio= 0.3

So, the WACC= 0.3*(1-0.34)*0.03 + 0.7*0.1 = 0.0054 + 0.07 = 0.07594 or 7.594%

c. Given, debt to equity ratio is 2.

So, WACC= (2/3)*(1-0.34)*0.03 + (1/3)*0.1= 0.0132 + 0.033 = 0.0462 or 4.62%

d. It is given that the debt capacity is 20 cents for every dollar of asset value.

So, debt to value ratio= 20/100= 0.2 or 20%

Thus, WACC= 0.2*(1-0.34)*0.03 + (0.8)*0.1 = 0.0839 or 8.39%