Question

ABC company has unleveraged beta of 1.8, risk free rate of 4% and a market risk premium of 2%. The applicable tax rate is 30%.

The company needs to finance a new project having three different scenarios of financing:

Scenario Debt ratio Interest rate (before tax) EPS
Scenario 1 0% 0% $1.5
Scenario 2 30% 15% $3.5
Scenario 3 60% 20% $3.8

1- Calculate the WACC under Scenario 1 *

4.5%

7.6%

5.4%

3.3%

None of the above

2- Calculate the price per share under Scenario 1 *

$19.7

$18.5

$20.2

$21.5

None of the above

3- Calculate Beta Leveraged under Scenario 2 *

3.24

1.82

2.84

2.34

None of the above

4- Calculate the WACC under Scenario 2 *

18.6%

10%

9.2%

8.6%

None of the above

5- Calculate the price per share under Scenario 2 *

$40.32

$25.5

$39.8

$25.6

None of the above

6- Calculate Beta Leveraged under Scenario 3 *

2.05

3.85

3.69

2.78

None of the above

Answer 1

1. First, we calculate the cost of equity by CAPM. Re = Rf + beta x (Rm - Rf) = 4 + 1.8 x 2 = 7.6%. Since debt is 0%, the WACC will be 7.6% Option B.

2. Price per share will be calculated by the formula: Price = EPS/WACC = 1.5/0.076 = 19.736 Option A.

3. Beta leverage will be calculated assuming beta of debt is 0. Hence, beta leverage = Beta unleveraged /Equity percentage = 1.8 / (1/(1+debt ratio)) = 1.8/0.769 = 2.34 Option D. (As Debt ratio = debt/equity)

4. WACC = Rd x D/(D+E) x (1-T) + Re x E/(D+E) = 15 x (1-0.769) x (1-0.3) + 7.6 x 0.769 = 8.27% Option E.

5. Price per share = EPS/WACC = 3.5/0.0827 = 40.3199 Option A.

6. Beta leveraged = Beta unleveraged/ Equity percentage = 1.8/(1/(1+0.6)) = 2.78 Option D.