Question

) Which of the following statements are correct?

a. A company anticipates a perpetual debt level of £12 million at an interest rate of 4%. If the company’s tax rate is 35%, the present value of the interest tax shields is higher than 4 million.

b. An all-equity firm has a beta of 0.8. If the risk-free rate is 5% and the market risk premium is 4%, the WACC of the company is lower than 8%.

c. According to the CAPM, the ratio of the risk premiums of two assets is equal to the ratio of their betas.

d. Company A has £10 million in debt and £40 million in equity. A comparable company B has £100 million in debt and £200 million in equity. The equity beta of company B is 1.4. If both companies have a tax rate of 40%, zero debt beta, and follow a financial policy that implies a constant level

of debt, then the equity beta of company A is higher than 1.2.

Answer 1

a. A company anticipates a perpetual debt level of £12 million at an interest rate of 4%. If the company’s tax rate is 35%, the present value of the interest tax shields is higher than 4 million.

This statement is correct.

The present value of perpetual debt interest tax shield is given by = Perpetual debt*Tax rate

Present value of perpetual debt interest tax shield = £12 million*0.35 = £4.2 million.

This value is higher than 4 million

d. Company A has £10 million in debt and £40 million in equity. A comparable company B has £100 million in debt and £200 million in equity. The equity beta of company B is 1.4. If both companies have a tax rate of 40%, zero debt beta, and follow a financial policy that implies a constant level of debt, then the equity beta of company A is higher than 1.2.

This statement is correct

Asset beta is given by = Equity beta*Equity value/(Equity+debt*(1-tax rate)) + Debt beta*Debt value/(Equity+debt*(1-tax rate))

Asset beta of B = 1.4*200/(200+100*(1-0.4)) + 0 = 1.0769

Equity beta of company A using comparable firm's asset beta = 1.0769*(40+10*(1-0.4))/(1.2*40) = 1.256

This is higher than 1.2

b is incorrect

According to CAPM model, WACC of all equity firm = Risk-free rate + Beta*(Market risk premium)

WACC = 0.05+0.8*0.04 = 0.082 = 8.2%

c is incorrect

According to the CAPM, .Required rate of return = Risk-free rate + Beta*(Market risk premium). Only considering Beta is incorrect.