Question

WACC Comparables - 1 Hula Enterprises is considering a new project to produce solar water heaters. The finance manager wishes to find an appropriate risk adjusted discount rate for the project. The (equity) beta of Hot Water, a firm currently producing solar water heaters, is 1.4. Hot Water has a debt to total value ratio of 0.2. The expected return on the market is 0.11, and the riskfree rate is 0.02. Suppose the corporate tax rate is 30 percent. Assume that debt is riskless throughout this problem. (Round your answers to 2 decimal places. (e.g., 0.16))

a. The expected return on the unlevered equity (return on asset, R0) for the solar water heater project is ____%.

b. If Hula is an equity financed firm, the weighted average cost of capital for the project is ______%.

c. If Hula has a debt to equity ratio of 2, the weighted average cost of capital for the project is _____%.

d. The finance manager believes that the solar water heater project can support 40 cents of debt for every dollar of asset value, i.e., the debt capacity is 40 cents for every dollar of asset value. Hence she is not sure that the debt to equity ratio of 2 used in the weighted average cost of capital calculation is valid. Based on her belief, the appropriate debt ratio to use is _____%. The weighted average cost of capital that you will arrive at with this capital structure is _____%.

Answer 1

unlevered beta = equity beta/(1+((D/E)*(1-t)))

D/E = debt to equity ratio

t = tax rate

weighted average cost of capital in case of an all equity firm would be equal to expected return on unlevered equity, since unlevered beta is beta of a firm as if it were unlevered (without any debt).

for part d) $1 of asset = 40 cents of debt

since 1$ =100 cents

$100 = 4000 cents = $40 of debt

debt to asset ratio = debt value/ asset value = 40/100 = 40%

3 expected return on market 4 risk free rate 5 tax rate 0.11 0.02 0.3 7 unlevered beta 1.191489 9 expected return on unlevered equity 10 b 11 weighted average cost of capital 12.72% 12.72% 13 debt to equity ratio 14 debt to asset ratio 15 equity to asset ratio 16 cost of levered equity 17 weighted average cost of capital 18 d) 19 based on manager's belief 20 debt to asset ratio 21 equity to asset ratio 22 appropriate debt ratio to use 23 weighted average cost of capital 2 0.666667 0.333333 0.341702 12.32% 0.4 0.6 40.00% 21.06%

1 equity beta 2 debt to total value 3 expected return on market 4 risk free rate 5 tax rate 1.4 0.11 0.02 7 unlevered beta 9 expected return on unlevered equity 10 b 11 weighted average cost of capital -B4+B7*(B3-B4)) -B9 13 debt to equity ratio 14 debt to asset ratio 15 equity to asset ratio 16 cost of levered equity 17 weighted average cost of capital 18 d 19 based on manager's belief 20 debt to asset ratio 21 equity to asset ratio 22 appropriate debt ratio to use 23 weighted average cost of capital 2 -B13/(1+B13) 1-B14 B9+(B13 (B9-B4)) B14 B4 1-B5))+B15 B16) 0.4 1-B20 -B20 B22 B4 (1-B5))+(B21 B16)