Answer in excel format please!
Answer in excel format please!
Consider firm B as an unlevered firm and firm C as alevered firm with target debt-to-equity ratio (D/E)*= 1. Both firmshave exactly the same perpetual net operating income (EBIT) of$180, before taxes. The before-tax cost of debt is the same as therisk-free rate. The corporate tax rate is 50%. Given the followingmarket information,
E(Rm) =12% s(Rm) =0.12 Rf= 6%
Beta (B)=1 Beta(C)=1.5 sisthe standard deviation of returns.
a)Find the cost of capital and valuefor each firm.
b)Evaluate the following four projects(I, II, III, & IV) to determine their acceptance (or rejection)by firms B andC. [Note:Beta of eachproject can be computed byCorrelation*[(R)/(Rm)], where is the standarddeviation of returns.
|
Projects |
Initial Costs |
Expected (EBIT) |
Standard Deviation s(R) |
Correlations |
|
I |
100 |
9 |
0.10 |
0.6 |
|
II |
120 |
11 |
0.11 |
0.7 |
|
III |
80 |
9 |
0.12 |
0.8 |
|
IV |
150 |
18 |
0.20 |
0.9 |
Answer:
| a | Levered Firm | Unlevered Firms | ||||||||||
| E(Rm) | 12% | E(Rm) | 12% | |||||||||
| Rf | 6% | Rf | 6% | |||||||||
| Cost of Equity | Cost of Equity | |||||||||||
| ER | ER | |||||||||||
| Expected Return | Risk Free Rate +Beta(RM -RF) | Expected Return | Risk Free Rate +Beta(RM -RF) | |||||||||
| .06+1.5(.12-.06) | .06+1.0(.12-.06) | |||||||||||
| 0.15 | 0.12 | |||||||||||
| Cost of debt | Cost of debt | |||||||||||
| The interest cost is same as the risk free ratebefore tax | Since it is an unlevered firm so no debt | |||||||||||
| i(after tax cost of Debt ) | ||||||||||||
| .06*.5 | ||||||||||||
| 0.03 | ||||||||||||
| Therefor the WACC of the Firms | Therefor the WACC of the Firms | |||||||||||
| Since the debt to equity ratio is 1 therefore thetotal is Debt | Since there is no debt therefore the full isequity | |||||||||||
| (0/1 *.15 + 1*.03) | (1*.12 +0) | |||||||||||
| 0.03 | 0.12 | |||||||||||
| b | Calculation of Beta for the Four Projects asbelow: | |||||||||||
| Formula for Beta=Correlation *[R/RM) | ||||||||||||
| Projects | Stand Deviation | Correlation | Beta | RM | R/RM | |||||||
| i | 0.1 | 0.6 | 0.5 | 0.12 | 0.833333 | |||||||
| ii | 0.11 | 0.7 | 0.641667 | 0.12 | 0.916667 | |||||||
| iii | 0.12 | 0.8 | 0.8 | 0.12 | 1 | |||||||
| IV | 0.2 | 0.9 | 1.5 | 0.12 | 1.666667 | |||||||
| Now the Cost of Capital is determied for the fourprojects as below; | ||||||||||||
| Initial Cost | EBIT | After Tax | After Discounting | Loss | ||||||||
| I | Risk Free Rate +Beta(RM -RF) | .06+.5(.12-.06) | 0.09 | 100 | 9 | 4.5 | 4.128 | -95.872 | ||||
| II | Risk Free Rate +Beta(RM -RF) | .06+.65(.12-.06) | 0.01 | 120 | 11 | 5.5 | 5.45 | -114.55 | ||||
| III | Risk Free Rate +Beta(RM -RF) | .06+.8(.12-.06) | 0.108 | 80 | 9 | 4.5 | 4.05 | -75.95 | ||||
| IV | Risk Free Rate +Beta(RM -RF) | .06+1.5(.12-.06) | 0.15 | 150 | 18 | 9 | 7.83 | -142.17 | ||||
| Since the loss is less in case of Project III itcan be accepted by the unlevered firm since there is no debtinvolved in the calculation of WACC | ||||||||||||
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