Question

An analyst for Acme, R. Runner, has recommended 10that Y. Lee purchase shares in a private firm (a firm that is not traded on any exchange) called Dynamite Corp. Dynamite has 30% debt and 70% equity. R. Runner believes that Dynamite will generate a return of 10% over the next year. Since Y. Lee is new to the job,

he decides to do a little research on his own. He finds a company, Explosions Unlimited, that is very similar to Dynamite. Explosions has an equity beta of 1.05 and is composed of 40% debt and 60% equity. Should Y. Lee buy the stock? The expected return on the market is 12% and the expected risk-free rate is 5%.

Answer 1

We first find the un-levered Beta of the Explosions Unlimited

where is the levered beta

T is the tax-rate and D/E is the debt-to-equity ratio

= 1.05 / [(1+(1-0.3)*(2/3)] = 0.716

Now, we re-lever the equity using the debt-to-equity ratio of Dynamite corp

= 0.716*[1+(1.3*3/7)] = 1.115

Now, we find the required rate using CAPM model

= 0.05 + 1.115*(0.12-0.05) = 12.805%

Since, the required rate of return is higher than the estimated return of 10%, Y.Lee should not buy the stock