Fin550Midterm_2015_KEY.pdf

Remember the cost of equity for the division will

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Remember, the cost of equity for the division will reflect not only the business risk of the division, but also the financial risk associated with the leverage of the division. We already saw that the target debt to equity ratio for the division was 0.50 so that is what we will use to relever the beta. 0.42 1 0.50 0.63 e We can use the equity beta to determine the cost of equity by implementing CAPM. For the risk-free rate, we want to use the current risk-free rate. Exhibit 3.2 gives us current Treasury rates for maturities of 1-month and 10-years. Since we are estimating the cost of capital for the division, which presumably is long-term, we want to use a long-term rate. This eliminates the 1-month rate and thus we would use the 10-year rate. For the market risk premium, we will need to estimate it from historical premiums. Exhibit 3.2 provides different types of risk premiums for different lengths of time. The first set of premiums is the returns of MOLE in excess of Treasuries, while the last is the returns of the industry in excess of Treasuries. Neither of these is usable. Remember that the market risk premium is not based on the particular asset you are valuing, rather it deals with the MARKET as a whole. This leaves us with the S&P returns in excess of Treasuries (the middle set of premiums). We want to match the maturity/scope of the risk premium with whatever we chose for the risk-free rate. Thus, the premium over 1- month bills doesn’t make sense since we used long-term rates for the risk-free rate. We would want to use the premium over 10-year bonds. Thus, the cost of equity for the CEG division would be: e R 0.06 0.63(0.07) 0.1034 10.41%
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16 9. At its target capital structure, what is the WACC for the firm as a whole? (20 points) The weighted average cost of capital (WACC) is defined as: (1 ) d e D E WACC R R V V where D represents the market value of debt, E is the market value of equity, V is the market value of the firm (debt plus equity), R d is the cost of debt, R e is the cost of equity, and τ is the corporate tax rate. Let’s determine each component in turn. To get the capital structure weights, we need the market values of debt and equity. In Exhibit 3.1., we have the market value of equity is $4,500 million, and we know that the market value of debt is $1,500 million. The value of the firm V is just the sum of the debt and equity: $1,500 + $4,500 = $6,000 million. With that, we know that the capital structure weights are: 1,500 4,500 0.25 0.75 6,000 6,000 D E V V We are also told in Exhibit 3.1. that the applicable tax rate is 40%. Hence, all that is left to do is to determine the cost of debt and the cost of equity. As we saw with the Roche case, there are several ways to estimate the firm’s cost of debt. Ideally we would determine the yield to maturity (YTM) on the firm’s own bonds. If that is not available, we could use the YTM of bonds of comparable firms, or use Treasuries as a benchmark and add a spread to account for the bond’s risk.
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