Question

You are trying to calculate the WACC for two firms. Firm XiG is publicly traded and firm TanW is a private firm. You have collected all necessary information for your WACC calculation:

In terms of liabilities, XiG has account payables of $400Million and a bank loan of $200Million. XiG also has cash holding of $300Million. XiG is current trading at $520/share with 1 Million shares outstanding. XiG’s returns move one to one with the stock market returns.

XiG’s average tax rate is 30% and marginal tax rate of 35%. XiG is rated as Aa1 by Moody’s and similar Aa1 rating firms have cost of debt of 2%. Risk free rate is 1%, market risk premium is 5%.

TanW is in the same industry as XiG. After consulting with an industry expert, you are confident that TanW and XiG have roughly the same business risk. Currently, TanW has net debt to equity ratio of 2. TanW’s average tax rate is 30% and marginal tax rate of 35%. Its cost of debt is 3%.

Now you proceed to calculate the WACC for both firms

Q1. Which firm’s cost of equity (rE) can only be calculated using comparable method?

1. XiG
2. TanW
3. Both
4. Neither

Q2. What is the net debt for XiG?

Input the net debt for XiG: $____ Million

Q3. What is the market value of equity for XiG?

Enter the market value of equity for XiG: $_____Million

Q4. What is WACC for XiG?

            Enter the WACC for XiG: ___% (keep two decimal points)

Q5. What is the asset beta for TanW?

1. 1.01
2. 1.24
3. 1.51
4. 1.60

Q6. What is the WACC for TanW?

1. 6.58
2. 7.12
3. 7.83
4. 8.65

Answer 1

Q1. Which firm’s cost of equity (rE) can only be calculated using comparable method?

The correct answer is option 2. TanW

TanW is a private company. Hence, it will not have a share price history and hence it's beta can't be estimated using correlation with the market. And hence, it's cost of equity can't be computed using CAPM. It's cost of equity can be calculated using comparable method only.

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Q2. What is the net debt for XiG?

Input the net debt for XiG: = Debt - Cash = 200 - 300 = $ - 100 Million. Hence, please input - 100 as answer.

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Q3. What is the market value of equity for XiG?

Enter the market value of equity for XiG = price x Number of shares = 520 x 1 million =  $ 520 Million

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Q4. What is WACC for XiG?

Enter the WACC for XiG: ___% (keep two decimal points)

Net Debt, D = - 100, Equity, E = 520; Wd = proportion of net debt = D / (D + E) = -100 / (-100 + 520) = -23.81%

We = proportion of equity = 1 - Wd = 1 - (-23.81%) = 123.81%

Kd = cost of debt = 2%; Risk free rate is 1%, market risk premium is 5%. XiG’s returns move one to one with the stock market returns. Hence, Beta = 1

Ke = Cost of equity = Rf + Beta x Market risk premium = 1% + 1 x 5% = 6%

T = marginal tax rate = 35%

the WACC for XiG = Wd x Kd x (1 - T) + We x Ke = -23.18% x 2% x (1 - 35%) + 123.81% x 6% = 7.12%

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Q5. What is the asset beta for TanW?

Unlevered beta of XiG = Levered beta / [1 + D / E] = 1 / [1 + 200 / 520] = 0.72

Value of the firm Xig = D + E = 200 + 520 = 720

Asset beta for TanW = Asset beta of XiG = Unlvered beta / (1 - cash holding% as value fo the firm) = 0.72 / (1 - 300 / 720) = 1.24. Hence the correct answer is option b. 1.24

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Q6. What is the WACC for TanW?

Levered beta of TanW = 1.24 x (1 + D / E) = 1.24 x (1 + 2) = 3.71

Cost of equity, Ke = Rf + levered beta x Rmp = 1% + 3.71 x 5% = 19.57%

Cost of debt, Kd = 3%; Marginal tax rate, T = 35%

D / E = 2; Hence, Wd = D / (D + E) = 2 / (2 + 1) = 2/3 = 0.67

We = 1 - Wd = 1 - 0.67 = 0.33

hence, WACC = Wd x Kd x (1 - T) + Ke x We = 0.67 x 3% x (1 - 35%) + 0.33 x 19.57% = 7.83%

Hence, the correct answer is option c. 7.83