Question

Ms Cersei Lanister is the CFO (chief financial officer) of the company Iron Throne Inc. The market value of the shares of this company is $5,000 million and the market value of debt is $4,000 million. Ms Lanister wants to evaluate several investment opportunities in order to maximize the value of the company. These investment opportunities offer all offer a similar level of risk and they will be financed with the same capital structure as the subsidiary company Highgarden Inc. For this reason, the cash flows of the projects must be discounted at the same cost of capital (WACC) as the subsidiary company. Determine the WACC of the projects using the following information with respect the subsidiary company: Book value of equity = $500 million; Market value of equity = $1500 million; Market value of debt = $300 million; Debt spread = 1%; risk free rate = 9%; Market return = 15%; Variance of the return on the company’s equity = 9; Variance of the return of the market = 6; Covariance of the market return with the return on equity = 4.8; corporate tax rate = 40%.

Answer 1

Solution:

Particulars   Market Value (S's in millions) Proportion=market value/sum of market value Cost Weighted cost

Debt $300 23.08% 6.00% 1.38%

Equity $1,000 76.92% 19.00% 14,2%

$1,300

Weighted Average Cost of capital.= 16.00°

So projects WACC is 16%,

Note: Beta of value = Covariance of value with market/change of market = 10, 6 = 1.667 times

according to capital resource estimating model (CAPM),

Cost of value =Ke= risk-free rate + stock's beta *(market return - risk-free rate)

= 9% + 1.667*(15% - 9%)

Cost of value = Ke.= 19%

Cost of debt =risk free rate + debt spread = 9%+ 1%=10%

After tax cost of debt = cost of debt(1-charge rate) =10 %*( 1-0.4) = 6%

Therefore projects WACC = cost of debt + after tax cost of debt = 10% + 6%

=16%,