Question

As the CFO of Finance Rocks (FR) Inc., you are considering building a book factory. You determine that you will use a D/E ratio of 2 and that after-tax cost of debt is 5%. To get the cost of equity for the factory you plan to use information from a comparable firm, Accounting Not So Much (ANSM) Inc. The beta on ANSM’s stock is 1.2 and its D/E is 1. If the T-bond rate is 6%and the market risk premium is 5.5%. The tax rate for FR and ANSM is 40%.

a.What is the cost of equity for the project?

b.What is the project’s WACC?

Answer 1

a

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

1.2 = Unlevered Beta*(1+((1-0.4)*(1)))

Unlevered Beta = 0.75

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

levered beta = 0.75*(1+((1-0.4)*(2)))

levered beta = 1.65

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 6 + 1.65 * (5.5)

Expected return% = 15.08

b

D/A = D/(E+D)

D/A = 2/(1+2)

=0.6667

Weight of equity = 1-D/A

Weight of equity = 1-0.6667

W(E)=0.3333

Weight of debt = D/A

Weight of debt = 0.6667

W(D)=0.6667

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=5*0.6667+15.08*0.3333

WACC% = 8.36