Corporate finance

pooja923
Good Student
Posts: 25
Joined: Fri Mar 11, 2016 11:38 am

Corporate finance

Postby pooja923 » Sat May 21, 2016 4:42 am

Utilitarian Co. is looking to expand its appliances division. It currently has a beta of 0.9, a D/E ratio of 2.5, a marginal tax rate of 30%, and its debt is currently yielding 7%. JF Black, Inc. is a publicly traded appliance firm with a beta of 0.7, a D/E ratio of 3, a marginal tax rate of 40%, and its debt is currently yielding 6.8%. The risk-free rate is currently 5% and the expected return on the market portfolio is 9%. Using this data, calculate Utilitarian's weighted average cost of capital for this potential expansion.
    4.2%.
    5.7%.
    7.1%.

In the explanation it is given: Beta of JF is the Equity Beta, We first calculate the Asset Beta of JF and then use it calculate Utilitarian's Equity Beta.
Why can't we directly use the Utilitarian's Beta of 0.9 ??

edupristine
Finance Junkie
Posts: 722
Joined: Wed Apr 09, 2014 6:28 am

Re: Corporate finance

Postby edupristine » Sat May 21, 2016 5:41 am

Hi Pooja
solution:
Just hink of it as the Dupont formula for beta (Note: the Equity mulitplier is Assets/equity or 1+D/E). Rememebr that ROE is the “Levered” version of ROA.
With ROE and ROA:
ROE = ROA x Equity Multiplier ==>
ROE = ROA x (1 + D/E)
vs. With Levered and Unlevered Beta:
Levered beta = Unlevered beta x [1+D/E(1-t)]
Since we’re talking about debt, there should be a tax adjustment. Hence the D/E is multiplied by “1-t”

JF Black’s asset beta:
βasset = βequity × (1 / (1 + ((1 – t)D/E)))
= 0.7 × (1 / (1 + 0.6(3)))
= 0.25
Utilitarian’s project beta, therefore, is:
β project = βasset × (1 + ((1 – t)D/E))
= 0.25 × (1 + 0.7(2.5)))
= 0.6875
Thus, Utilitarian’s cost of equity for this project is:
rCE = 5% + 0.6875(9% – 5%) = 6.3%
and their WACC is calculated
(2.5/3.5)(7%)(1 – 30%) ) + (1/3.5)(6.3%)
hence the answer is 5.71%

pooja923
Good Student
Posts: 25
Joined: Fri Mar 11, 2016 11:38 am

Re: Corporate finance

Postby pooja923 » Sat May 21, 2016 7:22 am

Thanks alot


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