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.

What is the net debt, market value of equity and WACC for XiG?

Answer 1

To find Net Debt of XiG we can use the following formula

Net Debt = Short-Term Debt + Long-Term Debt - Cash and Cash Equivalents

We have been given the following information

Short-Term Debt = account payables = $400 mn

Long-Term Debt = Bank Loan = $200 mn

Cash and Cash Equivalents = Cash Holding = $ 300 mn

So substituting these in the formula we get

Net Debt = 400+200-300

Net Debt = $ 300 mn

Market value of equity is also known as market capitalization,

To find this we need to multiply the current market price of a company's stock by the total number of shares outstanding.

We are given share price = $ 520

Share outstanding = 1 million

So market value = 520 * 1 million

Market value = $ 520 mn

To find WACC we will need the following information

Cost of Debt, Cost of Equity, Weight of debt and equity lets calculate them one by one

Cost of Equity

We can find this using CAPM model the formula for the same is

Ke​=Rf​+βi​(ERm​−Rf​)

where:

Ke =cost of equity

Rf​=risk-free rate

βi​=beta

(ERm​−Rf​)=market risk premium

We have been given risk free rate as 1% and market risk premium as 5%, we need to find beta

The question says “XiG’s returns move one to one with the stock market returns.” Mean beta of stock is 1

Let’s substitute these in the formula above and find cost of equity

Ke = 0.01 + 1*0.05

                =0.06 or 6%

So Cost of Equity is 6%

We are given Cost of Debt as 2%

We are given that TanW and XiG has similar business risk and Debt to Equity ratio of TanW is 2. Which mean the debt is more or twice as that of equity. As both have similar business risk we can use this ration to find the weights of debt and equity for XiG.

So the weight of debt = 2/3 or 0.67

And equity = 1/3 or 0.33

XiG’s average tax rate = 30%

For computing WACC we have the formula as given below

WACC = W_e*R_e + W_d*(R_d*(1-t))

Where

W_e = weight of equity

R_e =cost of equity

W_d = weight of Debt

R_d = Cost of debt

t = Tax rate

Substituting the information in the above formula

WACC = 0.67*0.06 + 0.33*(0.02*(1-0.3))

                =0.0402 + 0.33*(0.014)

                =0.0402 + 0.00462

                = 0.04482 or 4.482%

WACC = 4.482%