Max, Inc has $2.4 billion in assets and a debt-equity ratio of 6.0. Max has a be
ID: 2799273 • Letter: M
Question
Max, Inc has $2.4 billion in assets and a debt-equity ratio of 6.0. Max has a beta of 1.35 and its cost of debt is estimated to be about 6.5%. What is Max's WACC? Suppose Max's debt-equity ratio increases to 1.0. What will be its cost of equity? What will be its WACC? Risk-free rate=4%, MRP=7%.
MMD, Co. is a privately-held firm. In its industry the average beta is 1.60 and the average amount of leverage shows a debt-asset ratio of about .50. MMD employs less leverage-a debt asset ratio of about .25. Both the industry and MMD have a cost of debt of about 6.0%. What should be MMD cost of equity? What should its WACC be?
Explanation / Answer
Max, Inc has $2.4 billion in assets and a debt-equity ratio of .6.0. Max has a beta of 1.35 and its cost of debt is estimated to be about 6.5%. What is Max's WACC? Suppose Max's debt-equity ratio increases to 1.0. What will be its cost of equity? What will be its WACC? Risk-free rate=4%, MRP=7%.
The weighted average cost of capital (WACC) is the cost of raising capital, with the weights representing the proportion of each source of financing that is used.
WACC = wd * rd (1 - t) + we*re
Where,
Where Total asset of the company = Total Debt (D) + Total Equity (E) = $2.4 billion
wd is the proportion of debt of the company = D/ (D+E)
And debt-equity ratio (D/E) = 0.6 or D = 0.6E
Therefore D/ (D+E) = 0.6/ (0.6+1) = 0.6/ 1.6= 37.5%
rd is the cost of debt = 6.5% (assume that it is after-tax cost of debt; rd*(1-t) = 6.5%)
we is the proportion of equity of the company = E/ (D+E) = 1/(0.6+1) = 1/1.6 = 62.5%
re is the cost of equity, where
The cost of equity = risk free rate + * market premium
Where we have, risk free rate = 4%
Market Premium = 7%
And of the Max, Inc. = 1.35
The cost of equity = 4% + 1.35 * 7 % = 13.45%
Therefore,
WACC = 37.5% * 6.5% + 62.5% *13.45%
= 10.84%
Therefore WACC of the Max, Inc. is 10.84%
Suppose Max's debt-equity ratio increases to 1.0.
wd is the proportion of debt of the company = D/ (D+E) = 1/(1+1) = 50%
And we is the proportion of equity of the company = E/ (D+E) = 1/ (1+1) = 1/2 = 50%
The cost of equity will be same; the cost of equity = 4% + 1.35 * 7 % = 13.45%
And
WACC = 50% * 6.5% + 50% *13.45%
= 9.975%
Therefore WACC of the Max, Inc. is 9.975%
MMD, Co. is a privately-held firm. In its industry the average beta is 1.60 and the average amount of leverage shows a debt-asset ratio of about .50. MMD employs less leverage-a debt asset ratio of about .25. Both the industry and MMD have a cost of debt of about 6.0%. What should be MMD cost of equity? What should its WACC be?
MMD cost of equity = risk free rate + * market premium
Where we have, risk free rate = 4%
Market Premium = 7%
And of the Company = 1.60 (use industry average as the it is a privately-held firm)
The cost of equity = 4% + 1.60 * 7 % = 15.20%
And
WACC = wd * rd (1 - t) + we*re
Where,
wd is the proportion of debt of the company = D/ (D+E) = 0.25 or 25%
Where industry average = 0.5 or 50% but we have to take the company’s ratio
rd is the cost of debt = 6.0% (assume that it is after-tax cost of debt; rd*(1-t) = 6.0%)
we is the proportion of equity of the company = E/ (D+E) = 1 – {D/ (D+E)} = 1- 25%= 75%
Therefore,
WACC = 25% * 6.0% + 75% *15.20%
= 12.90%
Therefore WACC of the MMD, Co. is 12.90%