Question

Hula Enterprises is considering a new project to produce solar water heaters. The finance manager wishes to find an appropriate risk adjusted discount rate for the project. The (equity) beta of Hot Water, a firm currently producing solar water heaters, is 1.3. Hot Water has a debt to total value ratio of 0.5. The expected return on the market is 0.13, and the riskfree rate is 0.06. Suppose the corporate tax rate is 40 percent. Assume that debt is riskless throughout this problem. (Round your answers to 2 decimal places. (e.g., 0.16))

a.	The expected return on the unlevered equity (return on asset, R0) for the solar water heater project is  %.
b.	If Hula is an equity financed firm, the weighted average cost of capital for the project is %.
c.	If Hula has a debt to equity ratio of 0.4, the weighted average cost of capital for the project is  %.
d.	The finance manager believes that the solar water heater project can support 30 cents of debt for every dollar of asset value, i.e., the debt capacity is 30 cents for every dollar of asset value. Hence she is not sure that the debt to equity ratio of 0.4 used in the weighted average cost of capital calculation is valid. Based on her belief, the appropriate debt ratio to use is  %. The weighted average cost of capital that you will arrive at with this capital structure is %.

Answer 1

a. Expected Return on the unlevered equity

Using CAPM Model, Expected Return = Risk Free Return + Beta*(Market Return- Risk Free Return)

Expected Return = 6% +1.3*(13%-6%)

Expected Return = 6% + 1.3*7% = 6% + 9.10% = 15.10%

b. Calculation of Weighted Average Cost of Capital ( WACC) of HULA, if equity financed

WACC = (E/V)*ER of Equity + (D/V)*Debt Rate*(1-tax rate)

Where, E = Equity Value, Value = Total Value, D = Debt Value . ER of Equity = Expected Return of Equity, Debt Rate = Rate of Return on Debt

WACC = (1/1)*15.10% + (0/1)*6%*(1-40%)

WACC = 15.10%

c. Calculation of Weighted Average Cost of Capital ( WACC) of HULA, if debt to equity ratio is .4

Debt-Equity Ratio = Debt/Equity

.4 = Debt /Equity

Debt = .4*Equity

We know that, Total Value = Debt + Equity

Total Value = .4 Equity + Equity

Total Value = 1.4 Equity

Equity = .7143*Total Value and Debt = .2857*Total Value

WACC = (E/V)*ER of Equity + (D/V)*Debt Rate*(1-tax rate)

WACC = .7143*15.10% + .2857*6%*(1-40%)

WACC = 11.81%

d. Calculation of Weighted Average Cost of Capital ( WACC) of HULA, if debt to total value is 30%

Total Value = Debt + Equity

Equity = Total Value - Debt

Equity = Total Value - .3*Total Value

Equity = .7*Total Value

Now, we know, Debt-Equity = Debt/Equity

Debt-Equity = .3*Total Value/.7*Total Value = .3/.7 = 42.86%

WACC = (E/V)*ER of Equity + (D/V)*Debt Rate*(1-tax rate)

WACC = .7*15.10% + .3*6%*.60

WACC = 10.58%