Question

Pincrof Corporation has a current WACC of 6% at its target debt/assets ratio of 40% which is continuously adjusted. Pincrof plans to increase its target debt/assets ratio to 70% which would increase the cost of debt by 200 basis points (=+2%) p.a. to 4% p.a. We know that the corporate tax rate is 20%, the estimated market risk premium 5% and the risk-free rate 1% p.a. Pincrof's unlevered equity beta is

a. 1,032 b. 0,688 c. 0,752 d. 0,924

Answer 1

Solution:

WACC = Weight of equity * cost of equity + weight of debt * cost of debt

Debt / Asset = 40%, Equity / Asset = 1- 40% = 60%

D/E = 4/6 = 0.6667

Initial after tax cost of debt = 2% * (1-0.2) = 1.6%

6%= 0.6 * cost of equity + 0.4 * 1.6%

Cost of equity = (6% -0.64% ) / 0.6 = 8.9333%

According to CAPM

Cost of equity =Risk free rate + Beta * Market risk premium

8.9333% = 1% + Beta * 5%

Beta = 7.933333% / 5% = 1.5866

Levered beta = Unlevered beta ( 1 +D/E * (1-tax))

1.5866 = Unlevered beta * ( 1 +0.6667 * 0.8)

Unlevered beta = 1.586 / 1.5334 = 1.034

Correct option is A ) 1.032