Question

Maverick company is a publicly-traded company, with 20 million shares trading at $ 70 a share and $ 600 million in debt (market value as well as book value) outstanding. The firm derives 70% of its value from cloud storage and hosting, and the remaining 30% from technical service. The un-levered beta is 0.8 for firms in the cloud business and 1.2 for firms in the technical service business. Maverick company is rated A and can borrow money at 5%. The risk-free rate is 2% and the market risk premium is 8%; the corporate tax rate is 30%, and the firm has a capital gains tax rate of 20%

1. Estimate the cost of capital for Maverick Company.

Answer 1

Weight of Cloud = 0.7

Weight of Technical service = 0.3

Beta of Company = Weight of Cloud*Beta of Cloud+Weight of Technical service*Beta of Technical service

Beta of Company = 0.8*0.7+1.2*0.3

Beta of Company = 0.92

MV of equity = price*shares = 70*20 = 1400

Total Capital value = Value of Debt + Value of Equity

=600+1400

=2000

Weight of Debt = Value of Debt/Total Capital Value

= 600/2000

=0.3

Weight of Equity = Value of Equity/Total Capital Value

= 1400/2000

=0.7

D/E = 0.3/0.7 = 0.4285

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

levered beta = 0.92*(1+((1-0.3)*(0.4285)))

levered beta = 1.2

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 2 + 1.2 * (8)

Expected return% = 11.6

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 5*(1-0.3)

= 3.5

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=3.5*0.3+11.6*0.7

WACC =9.17%