you have taken a job as an investment analyst at the ABC investment fund. Your n
ID: 2802608 • Letter: Y
Question
you have taken a job as an investment analyst at the ABC investment fund. Your new boss has asked you to calculate the WACC of Haley grp. Haley is a low cap biotech public company, its investment projects typically last 4 - 6 years in length, and it has a BBB -debt rating. Yields to maturity for U.S treasury bonds are currently: 5yr=4.25% 10 yrs= 4.45 % 20 yr= 4.70% Corp debt yield spread to US treasuries as follows: a- = 1.95 BBB+ =2.3 % BBB= 2.65% BBB- =2.9% Your firm believes Haley's marginal tax rate is 43% and average tax rate is 38%. Haley's common stock is currently trading at $24.0 per share, and recently paid a dividend of $1.80 per share for the year. Based upon some analysis done by another investment analyst at InvestWell, your firm believes that Haley's dividents and earnings are expected to grow at a constant growth rate of 5% into the foreseeable future. Haley has only been public for approximately 3 yrs and as such no reliable third pary beta calculations are available. However you have been provided with the following information regarding one comparable company.: Super bio - Beta: 1.25, D/E: 98% Tax rates are not avail for either company - as such you are to use Haley's appropriate tax rate as proxy for the comparable company. Haley's rarget debt to value is currenlty 40%. Finally based upon some analysis done by your boss at ABC he believes that Haley will need to fund future equity requirement. with primarily new common stock issuances and expects flotation costs for such issuances to equal 4 %. A. Calculate the cost of debt on an after-tax basis. B. Calculate the cost of equity (using either the constant dividend growth model or the CAPM method. C. Calculate the weighter average cost of capital WAAC.
Explanation / Answer
Answer :
a) cost of debt can be calculated when coupon payment or interest rate is not given by adding the corporate debt spread by rating agencies with the risk-free rate of the US Treasury. In this case, Haley has BBB- rating which has corporate debt spread by 2.90% and we will take a US treasury rate or risk-free rate of 4.25% since its investment project horizon is for 4- 6 years. we will take average tax rate not marginal tax rate since that reflects the better picture of the tax of the company.
Cost of debt after tax: US risk-free rate for 5 years+ corporate debt spread for BBB- rating*(1- tax rate)
: 4.25%+2.90%*(1-0.38)
:4%
b) cost of equity by taking through constant dividend growth model. In this, we have taken formulae of
Ke=D1/P0*(1- flotation cost)+ g
Ke= cost of equity
D1 = Dividend of next year i.e D0*(1+g)
P0= Current price of the stock
Floatation cost
g= constant growth rate of dividend
=1.80*(1+0.05)/24*(1-0.02)+5%
=13%
c) WACC = It is calculated by taking an assumption that D/E is same for comparable company ie D/E is 98% or 0.98 while D/V of this company is 0.40 so after making it comparable we derive at E/V=0.41.
WACC= D/V*Kd+E/V*ke
=0.40*4%+0.41*13%
=7%
(ends)
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