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 1.4.
Hot Water has a debt to total value ratio of 0.3. The expected
return on the market is 0.11, and the riskfree rate is 0.06.
Suppose the corporate tax rate is 38 percent. Assume that debt is
riskless throughout this problem. |

a. |
The expected return on the unlevered equity (return on asset,
R_{0}) 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 40 cents of debt for every dollar of asset value, i.e., the debt capacity is 40 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 - tax) x D/E] = 1.4 / (1 + (1 - 38%) x 3/7) = 1.11

Expected return = Rf + beta x (Rm - Rf) = 6% + 1.11 x (11% - 6%) = 11.53%

b) WACC = Cost of equity = 11.53%

c) Levered beta = 1.11 x (1 + (1 - 38%) x 2) = 2.48

Cost of equity = 6% + 2.48 x (11% - 6%) = 18.39%

Weight of equity = D/E / (1 + D/E) = 2 / 3 = 67%, weight of debt = 33%

=> WACC = 66% x 6% x (1 - 38%) + 33% x 18.39% = 8.61%

d) D/E = 40 / 60 = 2/3

Levered beta = 1.11 x (1 + (1 - 38%) x 2/3) = 1.56

Cost of equity = 6% + 1.56 x (11% - 6%) = 13.82%

WACC = 40% x 6% x (1 - 38%) + 60% x 13.82% = 9.78%

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