ABC and XYZ are both mining services firms with comparable levels of asset risk;
ID: 2732101 • Letter: A
Question
ABC and XYZ are both mining services firms with comparable levels of asset risk; however, they operate with significantly different levels of leverage. The levered beta of XYZ is 1.7 and the firm has a D/E ratio of 80%. ABC has a D/E ratio of 25%. The risk-free rate is 2% and the market risk premium is 5%. The debt of ABC consists of a single syndicated bank loan at a rate of 5.5%. The marginal tax rate is 30%.
a. What is the levered beta of ABC? b. What is the cost of equity of ABC? c. What is the WACC of ABC?
Explanation / Answer
a. the levered beta of ABC = Comparable beta / (1 + D/E ratio) = 1.7 / (1 + 0.25) = 1.36
b. the cost of equity of ABC = rf + beta (Rm - rf=mr premium) = 2% + 1.36 * 5% = 8.8%
c. the WACC of ABC = 25/125 * 5.5% (1 - 0.30) + 100/125 * 8.8% = 0.77% + 7.04% = 7.81%