Question

Tunapuna Technologies (TT) is a privately traded firm with a target debt to value (D/V) ratio of 15% and current interest rate on debt of 6%.

Since the firm is privately traded, you turn to Arima Technologies (AT), TT’s closest publicly traded competitor, for data to estimate TT’s WACC. AT has a beta of 1.5 and a debt-to-value (D/V) ratio of 35%.

The current risk-free rate is 3.5%, the expected market risk premium is 6.5% (Rm-Rf), and the corporate tax rate for both firms is 40%.

(a) What is the “best estimate” of the equity beta for TT?

(b) What is the required return on equity for TT?

(c) What is the WACC for TT?

Answer 1

Answer a.

Arima Technologies:

Beta = 1.5
D/V = 35%

E/V = 100% - D/V
E/V = 100% - 35%
E/V = 65%

D/E = 35%/65%
D/E = 0.5385

Unlevered Beta = Levered Beta / [1 + (1-tax)*D/E]
Unlevered Beta = 1.5 / [1 + (1-0.40)*0.5385]
Unlevered Beta = 1.5 / 1.3231
Unlevered Beta = 1.13

Tunapuna Technologies:

Unlevered Beta = 1.13
D/V = 15%

E/V = 100% - D/V
E/V = 100% - 15%
E/V = 85%

D/E = 15%/85%
D/E = 0.1765

Levered Beta = Unlevered Beta * [1 + (1-tax)*D/E]
Levered Beta = 1.13 * [1 + (1-0.40)*0.1765]
Levered Beta = 1.13 * 1.1059
Levered Beta = 1.25

Best estimate of equity beta for TT is 1.25

Answer b.

Beta = 1.25
Risk-free Rate = 3.5%
Market Risk Premium = 6.5%

Required Return = Risk-free Rate + beta * Market Risk Premium
Required Return = 3.5% + 1.25 * 6.5%
Required Return = 11.625%

Answer c.

Cost of Debt = 6%
Weight of Debt = 15%
Weight of Equity = 85%
Cost of Equity = 11.625%
Tax Rate = 40%

WACC = Weight of Debt*Cost of Debt*(1 - tax) + Weight of Equity*Cost of Equity
WACC = 15%*6%*(1 - 0.40) + 85%*11.625%
WACC = 10.42%