Question

Pearson Ltd is financed through the following sources:

•  Ordinary share: 100 million shares outstanding, with current market price of

  one share at $2.2

•  Bank loan: $100 million borrowed from ANZ bank with an interest rate of 6%

•  Corporate bond: Pearson’s corporate bond is currently trading at 80% of its

  face value. The bonds pay coupons once per annum and have a total book value of $100 million. The current yield to maturity on the bond is 8% per annum.

  The risk-free rate is 3% and the market risk premium is 6%. It is estimated that Pearson has an equity beta of 1.5. Assume corporate tax rate is 30%, calculate the WACC for Pearson Ltd.

  Part B

  According to M&M proposition II, cost of equity increases with leverage. Cost of debt will also increase with leverage given higher probability of default. As both cost of equity and cost of debt are increasing when leverage increases, does it mean that leverage is bad for the firm value?

  Part C

  It can be observed that the average gearing ratio for the Pharmaceuticals industry is much lower than industries such as Utilities and Transportation. Explain why this is the case.

Answer 1