1. Compute the WACC for A.A.T. Bass & Co. using the information below: Book valu

Question

1. Compute the WACC for A.A.T. Bass & Co. using the information below:

Book value of bonds = $800 million   Maturity date = February, 2028 Equity beta = 1.30 Shares outstanding = 380 million

Tax rate = 35% Market price of bonds = 95.75% Coupon rate on bonds = 7.0% Book value of equity = $115 million

Price of common stock = $21.67 Yield on 10-year Treasury notes (Rf) = 2.0% Expected return on Market Portfolio (Rm) = 9.0%

2. Compute the asset beta for A.A.T. Bass & Co. using market values for debt and equity.

3. You are given the following information about the market portfolio: Expected return = 9%; standard deviation of returns = 15%; beta = 1.0; P/E ratio = 16 And you are given the following information about Bob’s Barrel Co.: Standard deviation of returns = 24%; P/E ratio = 11; beta = 0.88; div yield = 2.5% Assume the risk free rate is 1.5% and the corporate tax rate is 36%.

a) Compute the required return on Bob’s equity

b) Compute the correlation between Bob’s equity and the market portfolio

4. Heavy Metal Corporation is expected to generate Free Cash Flow of $75 million in the current year. The free cash flow is expected to grow at a 3% rate forever. Heavy Metal has 20 million shares outstanding, $400 million in debt and no excess cash. The tax rate is 40%, the required return on equity is 12%, and the WACC (cost of capital) is 9%. Compute the Enterprise Value of Heavy Metal and the value of the stock per share.

Explanation / Answer

1. Computation of WACC for A.A.T. Bass & Co.

Formula for WACC = Proportion of equity * cost of equity + Proportion of Debt * cost of debt after tax

Proportion of equity = market value of equity / value of the firm

here, market value of equity = Shares outstanding * price per share = 380 * 21.67 = 8,234.6

value of the firm = equity + debt = 8,234.6 + (800 * 95.75%) = 8,234.6 + 766 = 9,000.6

Proportion of equity = market value of equity / value of the firm = 8,234.6 / 9,000.6 = 0.91489

Proportion of Debt =market value of debt/ value of the firm = 766 / 9,000.6 = 0.085

cost of equity = Rf + beta ( Rm-Rf)

=2% + 1.3(9%-2%)=2% +9.1% = 11.1%

cost of debt after tax = 7% 91-35%) = 4.55%

Therefore, WACC = Proportion of equity * cost of equity + Proportion of Debt * cost of debt after tax

= 0.91489 * 11.1% + 0.085 * 4.55% = 0.10155 + 0.00386 = 0.1054 = 10.54% is the WACC

2. Computation of the asset beta for A.A.T. Bass & Co. using market values for debt and equity.

Betya of asset = beta of equity *1 / 1+ (1-tax rate) Proportion of Debt

= 1.3 *1 / 1+ (1-0.35) 0.085

=1.3 * 1 / 1.65 * 0.085

=1.3 * 1 / 0.140

=1.3 * 7.143

=9.29 is the Asset beta

3. a) Compute the required return on Bob’s equity

required return = Rf + beta ( Rm-Rf)

here, given beta = 1.0 and Rf =1.5%, Rm =15%

Therefore, required return = Rf + beta ( Rm-Rf)

=1.5% +1.0(15%-1.5%) = 1.5% +13.5% = 15% is the required return.

3.b) Compute the correlation between Bob’s equity and the market portfolio

formula for correlation = AB / equity*market

here, equity = standard deviation of return = 15% and market = standard deviation of portfolio = 24%

AB = 1 * (15%-9%) (24%-15%)

= 1 * (0.15-0.09) (0.24-0.15)

=1* (0.06) (0.09) = 1 * 0.0054

=0.0054

Threfore, correlation between Bob’s equity and the market portfolio = AB / equity*market

=0.0054 / 15% * 24% = 0.0054 / 0.036

=0.15 is thecorrelation between Bob’s equity and the market portfolio

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