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 and Asset Beta for both firms ?

Answer 1

1) Weighted Average Cost of Capital (WACC) = (Cost of Equity x Weight of Equity) + [Cost of Debt (after tax) x Weight of Debt]

Firm XiG

Cost of Equity = Risk free rate + (Beta x Market risk premium) = 1% + (1 x 5%) = 6% (Note: the Beta is equal to 1 because it is mentioned that XiG's returns move one to one with stock market returns)

Weight of Equity (assuming the par value of equity shares as $ 100) = Equity Share Capital / Total Capital Employed

= ($ 100 x 1 million shares) / $ 100 million + 200 million (Debt captial) = 100 million / 300 million = 0.3333

Cost of Debt given = 2%

After tax cost of debt = Cost of Debt x (1 - Marginal tax rate) = 2 x (1 - 0.35) = 1.3% (Note : Marginal tax rate is to be used)

Weight of Debt = 1 - weight of equity = 1 - 0.3333 = 0.6667

WACC = 6% x 0.3333 + 1.3% x 0.6667 = 1.9998 + 0.86671 = 2.86651 or 2.87%

Firm TanW

Cost of Equity will be same as that for XiG since both the firms have "roughly the same business risk". Hence, the Beta will be the same for both. Hence,Cost of equity = 6%

Weight of equity : It is given that TanW has a net debt to equity ratio of 2 , i.e., debt : equity = 2 : 1

Hence, Proportion or Weight of Equity = 1 / 3 = 0.3333

Cost of Debt after tax = 3% x (1 - 0.35) = 1.95%

WACC = 6% x 0.3333 + 1.95% x 0.6667 = 1.9998 + 1.3 = 3.2998 or 3.30%

2) Asset Beta = Beta of Equity x Weight of Equity

Note : The beta of Debt is always equal to zero, because debt is not related to, or influenced by, the stock market returns

Firm XiG = 1 x 0.3333 = 0.3333

Firm TanW = 1 x 0.3333 = 0.3333

Please check with the answer and let me know if there's any error in my approach.