Question

1. XYZ corp is a private company without publicly traded equity. you need to determine what XYZ's equity Beta would be if the company decided to go public. XYZ target equity ratio is 75%. below are XYZ 3 closet competitors.
             
Alsace.     Beta=1.44.   debt ratio=0.54
Parasol.   Beta=1.12.    debt ratio=0.22
Univex.     Beta=1.36.    debt ratio=0.42

what is XYZ expected equity beta?

2. assume that risk free rate of 1.55% and an equity market risk premium of 5.5%,what is XYZ equity cost of capital(re)? if you were unable to calculate XYZ in question 1,use a beta 1.21 for this calculation.

3. assume XYZ cost of debt is 200 basis points over the risk free rate,what is XYZ WACC? use tax rate of 25%. if you didn't calculate re in question 2 ,use 7.5 as XYZ equity capital.

4. what happens to XYZ WACC if tax rate increase to 35% . what generalization can you make about the relationship between corporate tax rate and company's WACC?

5. debt is cheaper that equity, so if XYZ changed its target equity ratio from 75% to 65% would reduce XYZ's WACC? why or why not? what happens to the cost of debt as leverage is increase?how does leverage affect equity beta?

please try to answer all my questions. its very important.

Answer 1

1.) We need to find the average beta of the closest competitor companies that generate income from similar operations as the private company. This will be a proxy for industry average levered beta.

The equity weighted average beta will be 1.25 appx.

The equity weighted average DE Ratio will be 0.34 appx.

βu = βL​​/ 1+ (1-T)*D/E

= 1.25/ 1 + (1-0)*0.34

=0.93

Now finally we need to relever it using the target Debt to Equity Ratio.

βL​​=βu*[1+(1+T)*D/E}

=0.93*[1+(1+0)*0.25]

=1.16

2.) Calculation of re using CAPM-

re = Risk Free Rate + Beta*Market Risk Premium

= 1.55 + 1.16*5.5

=7.93% (using Beta calculated above)

re = 1.55 + 1.21*5.5

= 8.21% (using Beta given)

3.) Calculation of WACC-

Cost of Debt = (1.55+2) (1- 0.25)

= 2.66%

Cost of Equity = 7.93%

WACC = 7.93*0.75 + 2.66*0.25

=6.61%

4.) If Corporate Tax increases to 35%

Cost of Debt = 3.55*(1-0.35)

= 2.31%

WACC = 7.93*0.75 + 2.31*0.25

= 6.53%

It can be said that there is inverse relation between WACC and Corporate Tax. If Tax increases, WACC decreases.

5.) WACC is simply the weighted average of Cost of Debt and Cost of Equity. So, the change in Target Equity to 65% will effect reduce WACC.