Question

Hula Enterprises is considering a new project to produce solar water heaters. The finance manager wishes to find an appropriate risk adjusted discount rate for the project. The (equity) beta of Hot Water, a firm currently producing solar water heaters, is 1.1. Hot Water has a debt to total value ratio of 0.3. The expected return on the market is 0.09, and the riskfree rate is 0.03. Suppose the corporate tax rate is 35 percent. Assume that debt is riskless throughout this problem. (Round your answers to 2 decimal places. (e.g., 0.16))

a.	The expected return on the unlevered equity (return on asset, R0) for the solar water heater project is__ %.
b.	If Hula is an equity financed firm, the weighted average cost of capital for the project is ___%.
c.	If Hula has a debt to equity ratio of 2, the weighted average cost of capital for the project is ___%.
d.	The finance manager believes that the solar water heater project can support 20 cents of debt for every dollar of asset value, i.e., the debt capacity is 20 cents for every dollar of asset value. Hence she is not sure that the debt to equity ratio of 2 used in the weighted average cost of capital calculation is valid. Based on her belief, the appropriate debt ratio to use is ___%. The weighted average cost of capital that you will arrive at with this capital structure is___ %.

Answer 1

a)	Unlevered beta = Levered beta/[1+(1-t)*D/E]
	Unlevered beta of solar water heaters = 1.1/(1+0.65*0.3/0.7) =	0.86
	Expected return on unlevered equity per CAPM = 3%+0.86*(9%-3%) =	8.16%
b)	WACC for equity financed firm = Expected return on unlevered equity =	8.16%
c)	After tax cost of debt = 3%*(1-35%) =	1.95%
	[Cost of debt = Risk free rate, as debt is risk free]
	Levered beta = 0.86*(1+0.65*2) =	1.98
	Cost of levered equity = 3%+1.98*(9%-3%) =	14.88%
	WACC = 1.95%*2/3+14.88%*1/3 =	6.26%
d)	Levered beta = 0.86*(1+0.65*0.2/0.8) =	1.00
	Cost of levered equity = 3%+1.00*(9%-3%) =	9.00%
	WACC = 1.95%*0.2+9.00%*0.8 =	7.59%