Question

I need Urgent on the correct way to solve this, step by step process. The answers are 7.62, 7.62,6.92,20% and 7.41. Please HELP!!!

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 1.1. Hot Water has a debt to total value ratio of 0.3. The expected return on the market is 0.09, and the riskfree rate is 0.03. Suppose the corporate tax rate is 35 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 2, the weighted average cost of capital for the project is ___%. d. The finance manager believes that the solar water heater project can support 20 cents of debt for every dollar of asset value, i.e., the debt capacity is 20 cents for every dollar of asset value. Hence she is not sure that the debt to equity ratio of 2 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) The solar water heater project's return on unlevered equity will be equal to the unlevered cost of capital of Hot Water as this firm is purely in the solar water heater business, thereby possessing business risk that is standard for the solar water heater business. Such standard business risk would require all firms in this business to have an equal unlevered return on equity(cost of capital).

Expected Market Return = 0.09 = Rm = 9 % and Risk-Free Rate = Rf = 0.03 or 3 %

Equity Beta of Hot Water = Be = 1.1 and Tax Rate = 35 %

Hot Water's Debt to Value Ratio = 0.3, Therefore, Debt to Equity Ratio = DE = 0.3/(1-0.3) = 3/7

Therefore, Asset Beta = Ba = 1.1 / [1+(1-Tax Rate) x DE] = 1.1/[1+(1-0.35) x (3/7)] = 0.86

Unlevered Cost of Equity for the Project = Rf + Ba x (Rm - Rf) = 3 + 0.86 x (9-3) = 8.162 %

(b) If Hula is equity financed, the firm's entire risk is encompassed by its asset beta (business risk) in the absence of debt and the consequent finance risk. Therefore, the solar water heater firm's (Hot Water) asset beta will be the appropriate risk measure for any solar water heater project undertaken by Hula.

Weighted Average Cost of Capital for Project (WACC) = Unlevered Cost of Equity of Hot Water = 8.162 %

(c) If Hula has debt, the firm's asset beta will be augmented by the financial risk of the debt, thereby making the firm's equity beta different from its asset beta and a correct measure of the firm's risks in projects related to the solar water heater market.

In this scenario, the asset beta for solar water heater projects (Hot Water's Asset Beta) augmented by the financial risk of Hula gives the appropriate risk measure of Hula's equity in this project. The required return on the riskless debt is further added to this equity return to arrive at the appropriate WACC for this project.

Hula's Debt to Equity Ratio = DE = 2

Equity Beta = 0.86 x [1+(1-0.35) x 2] = 1.98

Cost of Equity = 3 + 1.98 x (9-3) = 14.87 %

Cost of Debt = Risk-Free Rate = 3 %

Debt Proportion = D = 2/3 and Equity Proportion = 1/3

Therefore, WACC = D x (1-Tax Rate) x Cost of Debt + E x Cost of Equity = (2/3) x (1-0.35) x 3 + (1/3) x 8.83 = 6.257 %

(d) A debt ratio of 20 cents for 1$ of asset value implies a debt to value ratio of 0.2

Therefore, New Debt to Equity Ratio = 0.2/0.8 = 1/4

New Equity Beta = 0.86 x [1+(1-0.35) x (1/4)] = 1

New Cost of Equity = 3 + 1 x (9-3) = 9 %

Therefore, New WACC = 3 x (1-0.35) x (1/5) + 9 x (4/5) = 7.6875 % ~ 7.69 %