Exercise III - B - Correction PDF

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Exercise III B – The WACC- correction Exercise III B 1 - Target Assume the expected return on Target’s equity is 11.5%, and the firm has a yield to maturity on its debt of 6%. Debt accounts for 18% and equity for 82% of Target’s total market value. If its tax rate is 35%, what is an estimate of this firm’s WACC? Solution To compute the WACC, we need to know the costs of equity and debt, their proportions in Target’s capital structure, and the firm’s tax rate.

rwacc = rEE% + rD (1 − TC)D% = (0.115)(0.82) + (0.06)(1 − 0.35)(0.18) = 0.101 or 10.1%

Even though we cannot observe the expected return of Target’s investments directly, we can use the expected return on its equity and debt and the WACC formula to estimate it, adjusting for the tax advantage of debt. Target needs to earn at least a 10.1% return on its investment in current and new stores to satisfy both its debt and equity holders.

Exercise III B 2 - Honeywell The expected return on Honeywell International’s (HON) equity is 12.0%, and the firm has a yield to maturity on its debt of 5.1%. Debt accounts for 28% and equity for 72% of HON’s total market value. If its tax rate is 39%, what is this firm’s WACC? Solution rwacc = rEE% + rD (1 − TC)D% = (0.120)(0.72) + (0.051)(1 − 0.39)(0.28) = .0951 or 9.51% Honeywell needs to earn at least a 9.51% return on its investment in current and new stores to satisfy both its debt and equity holders. 2A ET –b Corporate Finance

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Exercise III B 3 - Caterpillar Suppose Caterpillar, Inc., has 665 million shares outstanding with a share price of $74.77, and $25 billion in debt. If in three years, Caterpillar has 700 million shares outstanding trading for $83 per share, how much debt will Caterpillar have if it maintains a constant debt-equity ratio? Solution E = 665 million × $74.77 = $49.7 billion, D = $25 billion, D/E = 25/49.722 = 0.503. E = 700 million × $83.00 = $58.1 billion. Constant D/E implies D = 58.1 × 0.503 = $29.2 billion.

Exercise III B 4 - Urskov Urskov has a target debt–equity ratio of 1.05. Its WACC is 9.4 per cent, and the tax rate is 35 per cent. (a)

If Urskov’s cost of equity is 14 per cent, what is its pre-tax cost of debt?

(b)

If instead you know that the after-tax cost of debt is 6.8 per cent, what is the cost of equity?

Solution: Using the equation to calculate WACC, we find: WACC = .094 = (1/2.05)(0.14) + (1.05/2.05)(1 – .35)RD RD = 0.0772 or 7.72%

Using the equation to calculate WACC, we find: WACC = .094 = (1/2.05)RE + (1.05/2.05)(.068) RE = 0.1213 or 12.13%

Exercise III B 5 – CAPM and WACC An all-equity firm is considering the following projects: Project

Beta

W

0.80

10

X

0.90

12

Y

1.45

13

Z

1.60

15

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The T-bill rate is 5 per cent, and the expected return on the market is 11 per cent. (a)

Which projects have a higher expected return than the firm’s 11 per cent cost of capital?

(b)

Which projects should be accepted if the CAPM return is used as the hurdle rate?

(c) Assuming that the decisions made in requirement (b) are correct, which projects would be incorrectly accepted or rejected if the firm’s overall cost of capital were used as a hurdle rate?

Answer: a.

Projects X, Y and Z.

b. Using the CAPM to consider the projects, we need to calculate the expected return of the project given its level of risk. This expected return should then be compared to the expected return of the project. If the return calculated using the CAPM is lower than the project expected return, we should accept the project, if not, we reject the project. After considering risk via the CAPM:

c.

E[W]

= .05 + .80(.11 – .05)

= .0980 < .10, so accept W

E[X]

= .05 + .90(.11 – .05)

= .1040 < .12, so accept X

E[Y]

= .05 + 1.45(.11 – .05) = .1370 > .13, so reject Y

E[Z]

= .05 + 1.60(.11 – .05) = .1460 < .15, so accept Z

Project W would be incorrectly rejected; Project Y would be incorrectly accepted.

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