Question

What discount rate is appropriate for finding the value of Artforever.com? Write a few paragraphs giving your answer and clearly explaining your reasoning and computations; show detailed computations in your Excel spreadsheet labeled Exhibit 1.

Cost of Debt = 6.2%

After tax rate - CoD = 6.2%*(1-tax rate) = 6.2% * (1-40%) = 3.72%

Considering the Market return, R_m = 8%

Risk-free rate, R_f = 2.5% (30 yr Treasury bond YTM)

Considering industry beta = 1.5

Cost of equity = R_f + beta*(R_m - R_f) = 8% + 1.5*(8% - 2.5%) = 10.75%

Artforever's debt-to-value ratio = 15%.

Hence Equity value would be 85% of V as D+E=V.

WACC/Discounting rate to be used would be = (D/E)*CoD + (E/V)*CoE

= 9.6955% = 9.7%

Answer 1

First let's understand what the enterprise value means. EV or V in this question is the total value of the company if it were to be liquidated today. In other words V is the amount any investor will have to pay for the company if it were to be sold today. Value (V) is calculated as the sum of the equity (E) and debt (D).

As per the question debt to value ratio is 15% which means that out of the total value of the company 15% is debt.

As D + E= V , means if debt is 15% of V equity will be the remaining part of V i.e. 85%.

Wacc or weighted average cost of capital is the discount rate that we use to value a company.

Wacc = ( weight of debt x cost of debt) + (weight of equity x cost of equity)

Weight of debt = debt to value ratio = D/V = 15%

( In the question it is written as D/E which is wrong it should be D/V which In other words is total weight of debt out of full value of company.)

Weight of equity = equity to value ratio= E/V = 85%

As per question cost of debt is 6.2% but after adjusting for tax it is given as 3.72% using formula CoD x (1- tax rate)

Cost of equity is calculated using CAPM ( Capital Asset Pricing Model ) as 10.75% using straight formula.

Putting values in wacc equation we get

Wacc = (0.15 x 0.0372) + (0.85 x 0.1075) = 9.6955%