Question

Triple Z, is providing car maintenance services for their customers in England, The Company is aiming to expand their business in the UK by establishing car services stations in Scotland. This project will cost the company £50 million. Triple Z decided to establish a separate company for this project and to name it Z Highlands. Z Highland plans to finance this project using 40% equity and 60% debt. T-bond annual rate 6.0%. Expected return on FTSE500 is 15%. The Variance of FTSE500 returns is 2. The covariance between FTSE500 and Triple Z is 1.6. Triple Z has had no debt for the last 5 years. (i.e. Debt/Equity = 0). The tax rate is 40%. Required: a) Calculate the following:

i) The Beta and cost of equity the Triple Z.

ii) The levered beta and the cost of equity for Z Highlands.

Answer 1

Cost of project=50 million

special purpose company named for this operation : Z Highland

Cost stucture for the project

Equity=40%;Debt=60%

T-bond annual rate =6.0%

Expected return on FTSE500=15%

Variance of FTSE500=2

Co variance between FTSE500 and triple Z=1.6

Triple Z has no debt for last 5 years

Tax rate =40%

1) Beta=Covariance/Varaince

Beta=1.6/2=0.8

Cost of equity:(Ke)

Ke=Rf+*(Rm-Rf)

Here= Rf=6%, Rm=15%

Ke=6%+0.8*(15%-6%)

Ke=13.2%

2) L=U*(1+(1-tax rate)*Debt/Equity)

As beta calculated for Triple Z is unlevered beta as it has no debt, and we will use this to calculate levered beta for Z higlands:

L=0.8*(1+(1-0.40)*(0.4/0.6)

L=1.12

Cost of equity for Z high lands:

Ke=Rf+L*(Rm-Rf)

Ke=6%+1.12*(15%-6%)

Ke=16.08%