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

Answer (2):

Cost of equity can be computed by CAPM Method.

CAPM Equation = Risk free rate + Beta ( Market Risk Premium)

= 1.55 % + 1.21(5.5%) = 8.205%

Answer (3):

WACC (Weighted Average Cost of Capital) can be computed by multiplying the cost of each capital component by its proportional weight.

WACC Formula: Weight of equity component X Cost of equity capital + weight of debt component X cost of debt capital

Note 1 : Weights of WACC are based on target capital ratio. In the present case, the target equity ratio is 75%, so the target debt ratio should be 25%.

Note 2 : Cost of debt should be net of tax.  

Note 3 : We are assuming cost of equity 8.205% computed in part (2) above.

Note 4: Calculation of cost of debt:

Cost of debt is 200 points over risk-free rate i.e. 3.55% (1.55% + 2%).

Net of tax cost of debt = 3.55X(1-.30) = 2.485%

WACC = 75% X 8.205% + 25% X 2.485% = 6.775%

Answer (4): If tax rate increase to 35 %, the after-tax cost of debt changed but cost of equity remains same.

Cost of Debt (Net of Tax) = 3.55 X (1-.35) = 2.3075%

WACC = 75% X 8.205% + 25% X 2.3075% = 6.730%

From above we can conclude that there is an invesrse relationship between corporate tax & WACC.
As corporate tax increases, WACC decrease.

Answer (5): Revised weight = Equity weight 65% , Debt weight 35%

WACC = 65% X 8.205% + 35% X 2.485% = 6.203%

Since debt is cheaper than equity, overall WACC reduced as proportion of debt rises.