Question

Question 1

1) Jim, a financial analyst, is valuing ABC Limited (“ABC”) using an equity and an asset-based approach. ABC’s only debt is a bank loan and it has a debt-to-equity ratio of 1 while its tax rate is 30%. The beta of ABC is 1.2, the risk-free rate is 2%, and the market risk premium is 8%. The bank loan’s interest rate is 6%.

(a) Calculate ABC’s cost of equity.

(b) Calculate ABC’s weighted average cost of capital (WACC).

2) Jim also wants to evaluate the credit quality of ABC Limited (“ABC”) with the following information:

ABC Limited	Year Ended 2019
Sales	$ 20,000,000
Cost of good sold	12,000,000
Depreciation	2,000,000
Operating income (earnings before interest and tax)	3,000,000
Interest expense	1,200,000
Income tax expense	400,000
Net income	1,400,000
Preferred shares dividends	500,000
Common shares dividends	800,000
Debt principal repayment	1,000,000
Tax rate	30%

Calculate ABC’s funds flow coverage ratio for BB Bank.

Answer 1

Question 1 A) We will calculate the cost of equityby using CAPM Equation

Cost of Equity = Rf + B(Rm -Rf)

Rf is risk free rate

B is beta

Rm is Market Return

(Rm - Rf) is Market risk premium

Cost of Equity = 2% + 1.2(8%)

= 11.6%

B) We will find the WACC by using formulae

WACC = Cost of equity * Weightage of equity + Cost of debt * Cost of debt ( 1 - Tax rate)

Debt-Equity Ratio = 1 Which means Debt and Equity is Equal (50% Weightage)

= (11.6% * 1/2) + 6%*1/2 ( 1 - 30%)

WACC = 7.9%

B) Funds Flow Coverage Ratio = (EBIT + Depreciation + Amortization) / Total Debt

= (30,00,000 + 20,00,000 ) / 1,000,000

= 5

Fund Flow coverage ratio = 5