Question

Answer in excel format please!

Consider firm B as an unlevered firm and firm C as a levered firm with target debt-to-equity ratio (D/E)*= 1. Both firms have exactly the same perpetual net operating income (EBIT) of $180, before taxes. The before-tax cost of debt is the same as the risk-free rate. The corporate tax rate is 50%. Given the following market information,

E(Rm) = 12%        s(Rm) = 0.12              R_f = 6%

Beta (B)= 1           Beta (C)= 1.5             sis the standard deviation of returns.

a)Find the cost of capital and value for each firm.

b)Evaluate the following four projects (I, II, III, & IV) to determine their acceptance (or rejection) by firms B andC. [Note:Beta of each project can be computed by Correlation*[(R)/(Rm)], where is the standard deviation of returns.

Projects	Initial Costs	Expected (EBIT)	Standard Deviation s(R)	Correlations
I	100	9	0.10	0.6
II	120	11	0.11	0.7
III	80	9	0.12	0.8
IV	150	18	0.20	0.9

Answer 1

a	Levered Firm						Unlevered Firms
	E(Rm)	12%					E(Rm)	12%
	Rf	6%					Rf	6%
	Cost of Equity						Cost of Equity
	ER						ER
	Expected Return		Risk Free Rate +Beta(RM -RF)				Expected Return		Risk Free Rate +Beta(RM -RF)
			.06+1.5(.12-.06)						.06+1.0(.12-.06)
			0.15						0.12
	Cost of debt						Cost of debt
	The interest cost is same as the risk free rate before tax						Since it is an unlevered firm so no debt
		i(after tax cost of Debt )
		.06*.5
		0.03
	Therefor the WACC of the Firms						Therefor the WACC of the Firms
	Since the debt to equity ratio is 1 therefore the total is Debt						Since there is no debt therefore the full is equity
		(0/1 *.15 + 1*.03)					(1*.12 +0)
		0.03					0.12
b	Calculation of Beta for the Four Projects as below:
	Formula for Beta=Correlation *[R/RM)
	Projects	Stand Deviation	Correlation	Beta	RM	R/RM
	i	0.1	0.6	0.5	0.12	0.833333
	ii	0.11	0.7	0.641667	0.12	0.916667
	iii	0.12	0.8	0.8	0.12	1
	IV	0.2	0.9	1.5	0.12	1.666667
		Now the Cost of Capital is determied for the four projects as below;
						Initial Cost	EBIT	After Tax	After Discounting	Loss
	I	Risk Free Rate +Beta(RM -RF)	.06+.5(.12-.06)	0.09		100	9	4.5	4.128	-95.872
	II	Risk Free Rate +Beta(RM -RF)	.06+.65(.12-.06)	0.01		120	11	5.5	5.45	-114.55
	III	Risk Free Rate +Beta(RM -RF)	.06+.8(.12-.06)	0.108		80	9	4.5	4.05	-75.95
	IV	Risk Free Rate +Beta(RM -RF)	.06+1.5(.12-.06)	0.15		150	18	9	7.83	-142.17
		Since the loss is less in case of Project III it can be accepted by the unlevered firm since there is no debt involved in the calculation of WACC