Question

Q 1.Which of the following statements is FALSE?

A. The WACC will always be higher than the cost of equity capital since it may involve debt which is riskier than equity.

B. A WACC is found by taking the weighted-average of the cost of debt capital and the cost of equity capital.

C. The WACC will be higher when the company has a greater systematic risk.

D. Using market values rather than book values is preferable when computing a weighted-average cost of capital (WACC).

Q 2. Which of the following is not an important consideration for the purposes of calculating a firm's Weighted Average Cost of Capital (WACC)?

A. Using market value of debt instead of book value of debt.

B. Amount of working capital a firm has used to support its operations.

C. Effect on capital structure when accepting a new project.

D. The average risk of the firm is the same risk for project being evaluated.

Q 3. What is the weighted-average cost of capital for the following firm that exists in a tax-free environment?:

Market Value of Debt = $30,000

Number of Shares = 6,000

Share Price = $15.60

Beta = 1.5

Risk-free rate = 4%

Market Risk Premium = 4%

Interest Rate on Debt = 8% (annualised)

A.14.06%

B. 9.51%

C. 8.93%

D. 4.97%

Q 4.Llehs is an oil & gas company that has been operating for several decades in Australia. It also operates in Latin America and the US. There has been increasing pressure on the company to decarbonise their portfolio and thus the company is looking into investing in renewable energy. It is considering a wind-energy project on the Australia West Coast. If the WACC for the Llehs is currently 18%, what discount rate should Llehs use when evaluating the wind-energy project?

A. 18%

B. More than 18% if the systematic risk of the wind-energy project is lower than that of an oil&gas project.

C. Less than 18% if the systematic risk of the wind-energy project is higher than that of an oil&gas project.

D. The WACC of a company that undertakes wind-energy projects in Australia only.

Q 5.

Given the information below, compute the after-tax WACC for Tiny Corp.Tiny Corp,

▪ Tiny Corp long term debentures were issued last week at par value of $30 000 000 with a yield of 8% (annual coupons)

▪ Tiny Corp has 50,000,000 shares outstanding. Each share is expected to pay a dividend of $0.50 in perpetuity at 4%.

▪ The beta (b) of Tiny Corp shares is 0.75

▪ The expected return on the market portfolio is 15%

▪ The risk-free rate is 5%

▪ The tax rate is 30%

A. 11.86%

B. 13.07%

C. 10.91%

D. 8.00%

Answer 1

A The WACC will always be higher than the cost of equity capital since it may involve debt which is riskier than equity.

This statement is clearly FALSE because debt is ideally less riskier than equity, thus providing a lower cost of debt, making WACC bounded by the cost of equity and limited by it, not exceeding it.

B. A WACC is found by taking the weighted-average of the cost of debt capital and the cost of equity capital.

This statement is TRUE because WACC is indeed the weighted average of the cost of debt captal and cost of equity capital.

C. The WACC will be higher when the company has a greater systematic risk.

A company with a greater systematic risk will have greater beta which in turn implies a higher cost of equity, atleast according to CAPM and that increases the WACC.

D. Using market values rather than book values is preferable when computing a weighted-average cost of capital (WACC).

Using market values is indeed more preferable as it reflects the actual costs of capital.

2) Important considerations for calculating WACC

A. Using market value of debt instead of book value of debt.

It is an important consideration for calculating WACC, it is done using market values

B. Amount of working capital a firm has used to support its operations.

WACC is calculated independent of firm efficiency, so it is not an important consideration

C. Effect on capital structure when accepting a new project.

It is important as capital structure will determine the weights of debt and equity, if the new project is too risky the cost of capital will change and hence, the WACC changes

D. The average risk of the firm is the same risk for project being evaluated.

It is an important consideration as partly explained in the previous option

3)

Market Value of Debt = $30,000

Number of Shares = 6,000

Share Price = $15.60

Beta = 1.5

Risk-free rate = 4%

Market Risk Premium = 4%

Interest Rate on Debt = 8% (annualised)

Market value of equity = Number of shares * Share price = 6000*15.6 = $93,600

After tax Cost of debt = 8%, as it is a tax free environment

Cost of equity can be found using CAPM

So cost of equity = risk free rate + Beta*Market risk premium

=4% +1.5*4% =10%

WACC = w-d*k-d + w-e*k-e

where

w-d = share of debt

w-e= share of equity

k-d = cost of debt

k-e = cost of equity

So,WACC = (30000/123600)*8% + (93600/123600)*10% = 9.5145%

So, option B

4)

what discount rate should Llehs use when evaluating the wind-energy project?

A. 18%

Not 18 % as that is the firm's WACC and that need to be the discount rate for the wind energy project which might have a higher or lower risk profile than that of the overall firm.

B. More than 18% if the systematic risk of the wind-energy project is lower than that of an oil&gas project.

if the systematic risk of the wind-energy project is lower than that of an oil&gas project then it should have a lower discount rate and not higher

C. Less than 18% if the systematic risk of the wind-energy project is higher than that of an oil&gas project.

if the systematic risk of the wind-energy project is higher than that of an oil&gas project then it should have a higher disount rate than the oil and gas project (proxy for Llehs as it is primarilyin the oil and gas industry) and not lower than 18%.

D. The WACC of a company that undertakes wind-energy projects in Australia only.

This is correct as one must use a discount rate which is more in line with the real scenario, and which accurately captures the riskiness of a wind energy project in Australia. One can take a proxy.

5)

The beta (b) of Tiny Corp shares is 0.75

▪ The expected return on the market portfolio is 15%

▪ The risk-free rate is 5%

▪ The tax rate is 30%

The market value of equity can be found form the dividend discount model

Also, required rate of return on the stock can be found from the CAPM, same as cost of equity

cost of equity = risk free rate + Beta*Market risk premium = 5% + 0.75*(15%-5%) = 12.5%

Now as per dividend discount model

Price =

Given g=4%

D0=0.5$

So Price of a share = 0.5*(1.04)/(0.085) = 6.11765$

The market value of equity = Number of shares * Share price = 50,000,000 * 6.11765= $305,882,352.9

Market value of debt (as they were issued last week only, not much change) = $30,000,000

After tax cost of debt = k-d*(1-t)

where

k-d = cost of debt = 8%

t=30%

So after tax cost of debt = 8%*(1-0.3) = 5.6%

WACC = w-d*k-d + w-e*k-e

where

w-d = share of debt

w-e= share of equity

k-d = cost of debt

k-e = cost of equity

w-d = 30000000/335882352.9 = 0.08932= 8.932%

and w-e = 305882352.9/335882352.9 = 0.91068=91.068%

Therefore, WACC = 0.91068*12.5% +0.08932*5.6% =11.8837%

Option A is correct