7.3. The following table provides the financial information of two companies in

Question

7.3. The following table provides the financial information of two companies in different businesses, with the dollar amounts in millions:

Company

Debt

Cost of debt

Equity

Cost of equity

Tax rate

Business

Meyer Co.

$30

11%

$110

15%

35%

Chemicals

Black Co.

$20

9%

$85

11%

33%

Retail stores

At present, the risk-free rate is 2.5% and the expected return on the market 9%. If Meyer Company wants to start a retail store chain as a side business, using its existing capital, what is the minimum acceptable rate of return on the new venture? From your analysis, can you deduce which is the riskier business, chemicals or retail stores?

Company

Debt

Cost of debt

Equity

Cost of equity

Tax rate

Business

Meyer Co.

$30

11%

$110

15%

35%

Chemicals

Black Co.

$20

9%

$85

11%

33%

Retail stores

Explanation / Answer

Part- A

In order to calculate the rate of return of the new venture, we need to calculate the WACC of Meyer & Co

The after tax cost of debt = Rd = 0.11*(1-0.35) = 0.0715

The cost of equity = 0.15

Weight of equity = We = 110/140 = 0.7857

Weight of Debt = Wd = 1-We =1-0.7857 = 0.2143

WACC = Wd*Rd + We*Re = 0.2143*0.0715 + 0.7857*0.15 = 0.1332

Hence minimum rate of return for Meyers Co is 13.32%

(b) which is riskier

We need to calculate beta of both as per CAPM

For meyers: Re = Rf + Beta *(Rm-Rf)

This will be 0.15 = 0.025+ beta*(0.09-0.025)

Hence Beta for Meyers Co is 1.92

For Balck Co: Re = Rf + Beta*(Rm-Rf)

This will be 0.11 = 0.025 +beta*(0.09-0.025)

Hence beta for Black Co is 1.31

Since Meyers is having a Higher beta, the Chemicals business is a riskier business

Related Questions

Navigate

• Browse (All)
• Browse 7
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.