Question

Grass & Weeds Gardening Co. has a target debt/equity ratio of 2.75. It’s existing bonds have a yield to maturity of 8%. Its outstanding stock has a beta of 0.75. The risk-free rate is 3% and the market risk premium is 7.5%. The tax rate is 40%. If the firm will finance it’s next project with 20% new equity and 80% new debt, what is the appropriate discount rate to use when analyzing the project’s NPV?
Select one:
a. 5.82%
b. 7.23%
c. 7.5%
d. 7.86%

Answer 1

Beta Of Leveraged = Beta of Unlevered * (1+ (1-Tax rate)*debt equity ratio))

0.75 = Beta of Unlevered*(1+1.65)

0.75/2.65 = Beta Of Unleaverd

Beta Of Unleaverd = 0.2830

Now Debt to Equity Ratio is 4.(80%/20%)

Beta of the levered firm = 0.2830*(1+(60%*4)) = 0.962

Expected return on equity = Rf + (beta*risk premium)= 3%+(0.962*7.5%) = 10.22%

Cost of Debt = 8%*(1+40%)= 4.8%

WACC = sum of (weight*cost)

=(80%*4.8%)+(20%*10.22%)

=5.88%

so the most nearest answer is option a.5.82% is correct option