Tag, Inc is considering a project in the paper business. It has 8m bond and 2m c
ID: 2736912 • Letter: T
Question
Tag, Inc is considering a project in the paper business. It has 8m bond and 2m common shares, a marginal tax rate of 37.5%, and its debt currently has a rate of return of 14%. R, a publicly traded firm that operates only in the paper business. its market value of equity is 3,800m and market value of debt is 0. It has an equity beta of 1.053 and a marginal tax rate of 37.5%.The risk-free rate is 4.25%, and the market risk premium is 6.7%.
Calculate R’s asset beta, the project’s equity beta, project cost of capital, and the appropriate WACC to use in evaluating the project.
Explanation / Answer
Solution.
1. Calculation of asset beta.
Formula = Equity beta / [ 1 + ( 1 - tax rate ) ( D/ E )]
= 1.053 / [ 1 + 0.6250 ( 0.80 / 0.20 )
= 0.162.
2. Project Cost of capital.
Through CAPM model.
Ke = 4.25% + 1.053 x 6.7%
= 11.30%
3. Calculation for WACC.
Cost of debt is 14% x ( 1 - .37.50 ) = 8.75%
WACC = 9%.
Capital Weight Cost WACC Debt 0.80 8.75% 0.07 Equity 0.20 11.30% 0.02 Total 0.09Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.