Question

You have been asked to determine a WACC for DressHouse, a mid sized regional women's clothing chain.

DressHouse has a debt-to-equity ratio is lower than usual at 40%. The tax rate is 30%. Your assistant has provided you with the following information on comparable firms.

Firm	Levered Beta	D/E Ratio
DressBarn	1.87	1.3
J. Jill	1.65	1.1
ChicWomen	1.35	0.7

So your next task is to determine the unlevered beta of each of these firms.

Using an average of those unlevered betas estimate a levered equity beta for DressHouse.

Given T-Bills are currently yielding 0.9% and the return on market is 7.2%, calculate the required return DressHouse's stock, according to the CAPM.

DressHouse, currently, has outstanding 10-year maturity bonds with a par value of $1,000 that pay a 6% annual coupon, that are selling for $1,015. Calculate DressHouse's required return on debt.

Based on your results above, calculate the weighted average cost of capital for DressHouse.

Answer 1

Levered Beta	D/E Ratio	Tax Rate t= 30% (1-t)*D/E	(1-t)*D/E	1+[(1-t)*D/E]	Levered Beta/{1+[(1-t)*D/E]}	Unlevered Beta
1.87	1.3	=(1-0.3)*1.3	0.91	1.91	=1.87/1.91	0.98
1.65	1.1	=(0.7)*1.1	0.77	1.77	=1.65/1.77	0.93
1.35	0.7	=(0.7)*0.7	0.49	1.49	=1.35/1.49	0.91

Average of Unlevered Beta= (0.98+0.93+0.91)/3 = 2.82/3 = 0.94

Thus, Unlevered Beta for Dress House using comparables method= 0.94; D/E Ratio for Dress House= 40% or 0.4

Levered Beta for Dress House: Unlevered Beta* {1+[(1-t)*D/E]} = 0.94* (1+(0.7*0.4)) = 0.94* 1.28 = 1.20

Required Return/ Cost of Equity using CAPM: Risk Free Rate + Levered Beta*(Market Rate of Return- Risk Free Rate)

Risk Free Rate= Rate of Return on Government T-Bills = 0.9%

Return on Market= 7.2%

Req. Rate of Return on Equity of Dress House= 0.9% + 1.20* (7.2% - 0.9%) = 8.46%

WACC= Weight of Debt* Cost of Debt + Weight of Equity* Cost of Equity

Cost of Debt= Yield to Maturity on Bonds

Yield to Maturity can be given by this equation:

Or this formula:

Where Coupon or PMT = 6%*1000= 60

Bond Price or PV (Present Value of Bond)= 1015

n or Number of Periods= 10

Face Value or Future Value FV = 1000

Plugging in the numbers in a Financial Calculator, we get YTM= 5.798 or 5.80%

WACC= 5.8* 0.4 + 8.46* 0.6 = 2.32 + 5.076 = 7.396 or 7.4%

Levered Beta (Equity Beta) Unlevered Beta (Asset Beta) 1 1 Tax Rate)(Debt/Equity) 1

Coupon 1 , Coupon 2 (1 +YTM)1 (1+YTM)2 Bond Price_ Coupon n Face Value

(1 + YTM)n Bond Price = Coupon x +(Face Value x (. YTM + YTM)