Question

Company ABC is currently unlevered. It uses CAPM to estimate the cost of common equity, and at the time of the analysis the risk-free rate is 5%, the market risk premium is 6% and the company's tax rate is 34%. It estimates that its beta now (which is unlevered because it currently has no debt) is .93 further, over the next two years, the companys Capital budgeting needs and and NI are as follows:

YEAR	Capital budgeting needs	Net Income
1	15 million	10 million
2	12 million	10 million

A. What is firm's current WACC?

B. how much can be paid out as dividends in each year according to the residual model Theory? Will the company have to raise external Equity to fund its capital budgeting need and if so, how much will it have to raise combine across the two years?

Answer 1

Solution A) According to the Capital Asset Pricing Model (CAPM), the required return on equity or cost of equity Ke is calculated as:

Ke = Rf + beta*(Rm - Rf)

Rf = Risk-free rate = 5%

Beta = 0.93

Rm - Rf = Market Risk Premium = 6%

Ke = 5% + 0.93*6% = 5% + 5.58% = 10.58%

WACC = Ke*we + wd*Kd*(1-tax%)

Ke = Cost of equity = 10.58%

we = Weight of equity = Equity/(Debt + Equity)

Since, the company has only equity, therefore, we = Equity/Equity = 1

Kd = Cost of debt

wd = Weight of debt = Debt/(Debt + Equity) = 0

Therefore, WACC = 10.58%*1 + 0 = 10.58%

Solution B)i) According to the Residual Model Theory, the dividends are paid when the cash available is more than the capital required for reinvestment.

For year 1:

The capital budgeting need is 15 million while the company earns a net income of $10 million

Excess cash = Net income - Reinvestment Capital = $10 million - $15 million = -$5 million

Hence, no excess cash is available and thus, the company will not pay any dividends.

For year 2:

The capital budgeting need is 12 million while the company earns a net income of $10 million.

Excess cash = Net income - Reinvestment Capital = $10 million - $12 million = -$2 million

Hence, no excess cash is available and thus, the company will not pay any dividends.

Solution B)ii) For year 1, excess cash = -$5 million

For year 2, excess cash = -$2 million

The company would be required to raise additional equity to fund capital projects for each year.

Solution B)iii) Total amount to be raised is $5 million in year 1 and  $2 million in year 2

= $5 million + $2 million = $7 million