Question

Holland Auto Parts is considering a merger with Workman Car Parts. Workman's market-determined beta is 0.9, and the firm currently is financed with 20% debt, at an interest rate of 8%, and its tax rate is 25%. If Holland acquires Workman, it will increase the debt to 60%, at an interest rate of 9%, and the tax rate will increase to 35%. The risk-free rate is 6% and the market risk premium is 4%. What is current required return to Workman's equity (before it is acquired)?

	a.	9.3%
	b.	7.4%
	c.	9.6%
	d.	9.7%
	e.	8.9%

Answer 1

Given (before acquisition) :

Beta(β) = 0.9

Risk free rate(Rf) = 6%

Market risk premium(Km-Rf) = 4%

Tax rate = 25%

Weight of debt in Workman's capital structure = 20%, interest rate =8%

Weight of equity = 80%

Using Capital Asset Pricing Model the cost of equity can be calculated as:

Ke = Rf + β (Km-Rf)

= 0.06 + 0.9 x 0.04

= 0.06 + 0.036

= 0.096 ie, 9.6%

The current required return to Workman's equity before it is acquired :

(Weight of debt x Cost of debt) + (Weight of equity x Cost of equity)

= (0.2 x 0.06) + (0.8 x 0.096)

= 0.012 + 0.0768

= 0.0888 ie, 8.9%

note: Cost of debt is calculated after tax because interest paid on debt is tax deductible. After tax cost of debt = Before tax cost of debt (1-tax rate),   0.08 (1- 0.25) = 0.06