Question

Alfaeba Corp has a current D/V-ratio of 85% with expected cost of debt 5,7% p.a. The levered equity beta is 2,5. A reduction to a target D/V-ratio of 50% is now planned lowering the expected cost of debt to 4% p.a. The corporate tax rate is 20%. The risk-free rate is 1% and the market risk premium 5% p.a. What will be Alfaeba Corp’s new WACC?

a. 5,901% b. 6,47% c. 6,021% d. 6,87%

Answer 1

Answer to the question :

Current Debt Equity Ratio = 85% i.e. 0.85

Current levered Beta = 2.5

Target Debt Equity ratio = 50% i.e. 0.50

Current cost of debt = 5.7%

Expected cost of debt at lower D/E ratio = 4%

Risk free rate = 1%

Market risk premium = 5%

Tax rate = 20%

Calculation of Beta of the company

First of all we have to calculate the unlevered beta of the company :

Unlevered Beta of company = Levered Beta of Industry

                                                            1 + D/E ratio (1-tax)

                                                     =     2.5

                                                            1+0.85(0.80)

                                                     = 1.4881

Levered Beta of Company = Unlevered beta of company * [1+D/E ratio (1-tax)]

                                                   = 1.4881 * [1+0.50*(0.80)]

                                                   = 2.0833

Calculation of WACC

Cost of equity (Ke) as per CAPM = Risk free rate + Risk Premium * Beta

                                                   = 1 + 5 * 2.0833

                                                   =11.4167%

Cost of debt (Kd) = Interest rate (1-tax)

= 4%*(0.80)

=3.2%

WACC= Weight of equity * Ke + Weight of debt *Kd

           = 0.50 * 11.4167% + 0.50 * 3.20%

           =7.30845 % that is approximately equal to 7.31%

Note: The answer which was calculated by me is correct to the best of my knowledge, and option for the same is not given. Kindly do follow my answer and consult the person whoever give you this question or the author of the book from where you get this question.