Question

Question 9.

A. Marble Paving Ltd. has a debt equity ratio of 1.5. The cost of debt is 8% and the cost of unlevered equity is 14%. Calculate the weighted average cost of capital for the firm if the tax rate is 33%. Briefly summarise the advantages of using the WACC to evaluate a project. [5 marks]

B. Suppose Shee SuperSteel Products conducts a study and concludes that if SSP significantly expanded its consumer products division (which is less risky than its core business of industrial/commercial products), the firm’s beta will decline from 1.4 to 1.0. However consumer products are more competitive and have a lower profit margin, which would cause the expected growth in overall company earnings to fall from 8.5% to 6.5%. The dividend recently paid was $2.40 per share. The rate of market return is estimated at 12.5% and the risk free rate is 6.5%. Should the consumer products division be expanded?

Answer 1

A) D/E = 1.5

Cost of Debt , Rd = 0.08

Cost of unlevered equity = 0.14

Tax = 33 percent

WACC = Equity weight * Cost of Equity + Debt Weight *Cost of Debt * (1-Tax)

= ( 2/5) * 0.14 + (3/5) * (0.06) * (0.67)

= 0.056 + 0.02412

= 0.08012

Hence , the WACC is 8 percent.

WACC is the minimum rate of return required to create value for the firm. The advantages are :

1. WACC is simple and easy to calculate

2. WACC can be reused for some other project with a similar risk profile

3. WACC can prompt swift and accurate decision making

2. Assuming , consumer products division is expanded ,

New beta = 1.0

Market rate of return = 12.5 percent

Rf = 6.5 percent

According to CAPM , the minimum required return is ,

Req. return = Rf + (beta * (Rm - Rf))

= 0.065 + (1*0.06)

=0.125 = 12.5 percent

Assume the consumer products division is not expanded ,

then Req return = 0.065 + (1.4 * 0.06) = 14.9 percent

The difference between required and expected returns , if expanded = 12.5 - 6.5 = 6 percent

The difference between required and expected returns , if not expanded = 14.9 - 8.5 = 6.4 percent

Hence , it would be prudent for Supersteel products to expand considering the risk and return.