Question

Firm XYZ has· £20M in equity and £1OM of debt in its balance sheet. All values are in market values. XYZ's financial policy is to keep a constant debt-to-capital ratio. Assume that the CAPM relation holds, the risk-free rate is 6%, and the expected market risk premium is 5%. The corporate tax rate is 40%. Choose those statements that are correct:

a. If XYZ's equity beta is 1 and its debt beta is zero, XYZ's asset beta is 0.73.

b. If XYZ's cost of equity is 12% and its cost of debt is 8%, XYZ's asset beta is 0.93. c. If XYZ's cost of debt is 7%, its debt beta is 0.20.

d. If XYZ's equity beta is 1 and its debt beta is zero, XYZ's weighted average cost of capital

0NACC) is 8.53%.

Answer 1

Answer: Options b, c and d are correct

Working Notes justifying the answer

Weight of debt (Wd) = 10/30 = 0.33
Weight of Equity (We) = 20/30 = 0.67

(a) Checking option a-
(Wd* debt beta) + (We* equity beta) = asset beta
= (0.33*0)+(0.67*1) = 0.67
Therefore, the answer is not accurate

(b) Checking option b-
Kd = Rf+ (Rm-Rf) *debt beta
8 = 6+ 5 * debt beta
debt beta = 0.4
Ke = Rf+ (Rm-Rf) * equity beta
12 = 6+ 5 * equity beta
equity beta = 1.2

Now, (Wd* debt beta) + (We* equity beta) = asset beta
(0.33*0.4) + (0.67*1.2) = 0.93
Therefore, this answer is correct

(c) Checking option c-
Kd = Rf+ (Rm-Rf) *debt beta
7= 6 + 5*debt beta
debt beta = 0.20
Therefore, this answer is also correct.

(d) Checking option d-

Kd = Rf+ (Rm-Rf) *debt beta
= 6 + 5*0 = 6%
Ke = Rf+ (Rm-Rf) *equity beta
= 6 + 5*1 = 11%

Now, calculation of WACC= (after tax cost of debt * debt weight) + (cost of equity * equity weight)
= [[6 *(1-0.40)] * 10/30] + [11 * (20/30)]
= 8.53 %
Therefore, this answer is also correct.