Question

4. Tri Co. has the following cost of debt structure (14’) wd 0% 20% 30% 40% 50% rd 0.0% 9.0% 10.0% 11.0% 12.0% The market risk premium is 4.5%, the risk free rate is 5%, beta of unleveraged firm is 1.20, Hamada’s equation b= bU [1 + (1 - T)(wd/we)]. T=40%. Please use the above information to answer following questions: a) If the firm uses 50% debt, what is the cost of equity of the firm, based on CAPM model? b) What is WACC of the firm? c) If the firm has infinite FCF1=35 million and grow at 5% forever, what is the firm’s value? ------ tax rate of 40% was just added-----

Answer 1

Solution:-

Here weight of debt (Wd)=50% , hence weight of equity would be(100-50)= 50%.

Now, We have

b= bU [1 + (1 - T)(wd/we)]

where,

bU= beta of unleveraged firm=1.20

T=tax rate =40%

Wd=weight of debt=0.50

We= weight of equity =0.50

Substituting the values

b=1.20*[1+(1-0.40)*(0.50/0.50)]

b=1.92 times

a) Cost of equity (Ke)

            Ke= Rf+b(Rm-Rf)

where

Rf= risk free return = 5%

Rm-Rf= Market risk premium= 4.5%

Substituting the values

            Ke= 5%+1.92*4.5%

                = 13.64%

b) Calculation of WACC of firm :-

Since weight of debt is 50% hence cost of debt will be 12.0%

WACC=Kd*(1-tax)*Wd+Ke*We

Where

Kd= cost of debt= 12%

tax = 40%

Wd= weight of debt= 0.50

Ke= Cost of equity= 13.64%

We= Weight of equity= 0.50

Substituting the values

WACC=12*(1-0.40)*0.50+13.64*0.50

            =3.6%+6.82%

            =10.42%

c) Value of firm =

          =FCF1/(WACC-g)

          =35 million/(0.1042-0.05)

          =35/0.0542

          =$645.76 million

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