Degen Company is considering a project in the commercial printing business. Its debt currently has a yield of 12%. Degen has a leverage ratio of 2.3 and a marginal tax rate of 30%. Hodgkins Inc., a publicly traded firm that operates only in the commercial printing business, has a marginal tax rate of 25%, a debt-to-equity ratio of 2.0, and an equity beta of 1.3. The risk-free rate is 3% and the expected return on the market portfolio is 9%. The appropriate WACC to use in evaluating Degen’s project is closest to: A) 8.6%. B) 8.9%. C) 9.2%. what do u think??
If you see a problem like this on the test, you’ll hear a chorus of groans from all of the Level I candidates when they see this question, don’t even bother doing it until you’ve finished every other question. You need to unlever your Beta with Hodgkins data and then relever using Degen data. Then you plug this Beta into CAPM to solve for Ke. Using the D/E ratio of Degen solve for the WACC components with the given inputs and adjust your debt for Tax. The answer is C.
Because I’m such a nice guy. unlevered b=levered b/(1+(1-T)(D/E)) unlevered b=1.3/(1+(.75)(2)) unlevered b=.52 Now relever levered b=unlevered b(1+(1-T)(D/E)) levered b=.52(1+(.7)(2.3)) levered b=1.357 ke=rfr + b(mr-rfr) ke=3 + 1.357(9-3) ke=11.14 kd=yield*(1-t) kd=12*(.7) kd=8.4 Now solve for WACC. Be careful with the D/E ratio. We=1/3.3=.303 Wd=1-We=.697 WeKe + WdKd=WACC (we already did the tax stuff) .303*11.14 + .697*8.4= 9.22
HAHA thanks Chuck…now i thought i was losing my mind. i had C too but alas: Your answer: C was incorrect. The correct answer was A) 8.6%. We are given Degen’s leverage ratio (assets-to-equity) as equal to 2.3. If we assign the value of 1 to equity (A/E = 2.3/1), then debt (and the debt-to-equity ratio) must be 2.3 − 1 = 1.3. Equity beta for the project: βPROJECT = 0.52[1 + (1 − 0.3)(1.3)] = 0.9932 Project cost of equity = 3% + 0.9932(9% − 3%) = 8.96% Degen’s capital structure weight for debt is 1.3/2.3 = 56.5%, and its weight for equity is 1/2.3 = 43.5%. The appropriate WACC for the project is therefore: 0.565(12%)(1 − 0.3) + 0.435(8.96%) = 8.64% . . . . crap.
It’s that damn leverage ratio. I misread that as D/E. Just subtract one from it as they do in the solution. I’m really starting to dislike the guys at Schweser.
i think we should make our own notes and practice exams and sell them for extortionate amounts of money.
Chuckrox8 Wrote: ------------------------------------------------------- > It’s that damn leverage ratio. I misread that as > D/E. Just subtract one from it as they do in the > solution. I’m really starting to dislike the guys > at Schweser. I thought you’re supposed to add 1 to these type of leverage ratios…, like if it was a D/E ratio of 0.5, then you add 1 to make it 1.5. Then D = 0.5/1.5 [.3333], while E = 1/1.5 [.6667]. Now with this question, I followed the same logic…, add 1 to 2.3 to make it 3.3, then for D = 2.3/3.3 = .6970; E = 1/3.3 = .3030. But ofcourse, that’s the wrong way to do it because I didn’t get the answer. So what’s the best way to adjust this leverage ratios? If it’s less than 1, add 1 to the ratio & if it’s more than 1, substract 1 from the ratio?
if financial leverage Assets/Equity = 2.3 then that means (E+L)/E = 2.3 2.3/1 = 2.3 then E+L=2.3, then L=2.3 - E, L= 2.3 - 1