Question

A large pharmaceutical company invites you to take an expert position in their new pot growing division. The division will be financed with $1 million in debt and $4 million in equity. The tax rate is 30% for all firms. The risk-free rate is 3% and market portfolio return is 9%. The yield on the division’s debt is 6%. The information on the relevant established pot growing companies is given below:

Name	Beta	Debt/Equity
Kush Bottles	1	0.2
Terra Tech	1.15	0.4
Aurora Cannabis	1.7	1.2

a) What is the average of the project betas of the pure play firms?

b) What is the beta of the new pot growing division of the pharmaceutical company?

c) What is the cost of equity of the division?

d) What is the division’s WACC?

Answer 1

a)

Kush Bottles

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

1 = Unlevered Beta*(1+((1-0.3)*(0.2)))

Unlevered Beta = 0.88

Terra Tech

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

1.15 = Unlevered Beta*(1+((1-0.3)*(0.4)))

Unlevered Beta = 0.9

Aurora Cannabis

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

1.7 = Unlevered Beta*(1+((1-0.3)*(1.2)))

Unlevered Beta = 0.92

Average beta = ( Kush Bottles Unlevered Beta+Terra Tech Unlevered Beta+ Aurora Cannabis Unlevered Beta)/3

=(0.88+0.9+0.92)/3=0.9

b)

Beta for pot growing division

D/E = debt/equity = 1/4 =0.25

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

levered beta = 0.9*(1+((1-0.3)*(0.25)))

levered beta = 1.06

c)

As per CAPM

expected return = risk-free rate + beta * (expected return on the market - risk-free rate)

Expected return% = 3 + 1.06 * (9 - 3)

Expected return% = 9.36 = cost of equity

d)

D/A = D/(E+D)

D/A = 0.25/(1+0.25)

=0.2

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 6*(1-0.3)

= 4.2

Weight of equity = 1-D/A

Weight of equity = 1-0.2

W(E)=0.8

Weight of debt = D/A

Weight of debt = 0.2

W(D)=0.2

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=4.2*0.2+9.36*0.8

WACC% = 8.33