Assignment-3.

1:
In order to use CAPM we shall need to derive a suitable equity beta for Moorland Co.
This will be done by first finding a suitable asset beta (based on the asset betas of the 2 parts of
the business) and gearing up to reflect Moorland Co's 50:50 gearing level.
Retail industry
The asset beta of retail operations can be found from the industry information as follows:
(assuming the debt beta is zero)
Ve
a= e
V e +V d ( 1T )
= 1.20 (80/(80 + 20(1 0.30)))
= 1.02
Manufacturing industry
Similarly, the asset beta for manufacturing operations is:
Ve
a= e
V e +V d ( 1T )
= 1.45 (55/(55 + 45(1 0.30)))
= 0.92
Moorland Co asset beta
Hence, the asset beta of Moorland will be a weighted average of these two asset betas:
a (Moorland) = (0.75 1.02) + (0.25 0.92) = 1.00
Moorland Co equity beta
So, regearing this asset beta now gives:
1.00 = e [50/(50 + 50(1 0.30))]
So, e = 1.00/0.59 = 1.69
Moorland Co cost of equity
Using CAPM:
Ke = RF + (E(RM) RF) = 3% + (1.69 6%) = 13.1%

Assignment-3.2:
Mackay Co's post tax cost of debt is 5(1 0.30) / 94.50 = 3.7%

Assignment-3.3:
To calculate IRR, we discount at 2 rates (5% and 10% here) and then interpolate:
PV at 5% = 89 (6(10.30) 5 yr 5% annuity factor) (100 5 yr 5% discount factor) = 7.58
PV at 10% = 89 (6(1 0.30) 5 yr 10% annuity factor) (100 5 yr 10% discount factor) =
10.98
Hence IRR (post tax cost of debt) is approximately 6%.

Assignment-3.4:
The overall cost of debt will be the weighted average of the costs of the two types of debt
(weighted according to market values).
2 year bonds
Market value = $30m 0.90 = $27m
kd = 2.5% + 50 credit spread (from table) = 3.00%
10 year bonds
Market value = $50m 1.08 = $54m
kd = 2.5% + 75 credit spread (from table) = 3.25%
Overall cost of debt
Therefore the weighted average cost of debt (given that the ratio of market values is 1:2) is
[((1/3) 3.00%) + ((2/3) 3.25%)] (1 0.30) = 2.22%

Assignment-3.5:
WACC=

] [

Ve
Vd
K e+
K (1T )
V e +V d
V e +V d d

Workings:
From CAPM, ke =Rf + i (E(Rm) Rf) = 6% + (1.25 8%) = 16%
Ve = $2,500,000 1.22 / 0.50 = $6.1m
kd (yield on debt) = risk free rate + credit spread = 6% + 65 basis points = 6.65%
Hence, post tax cost of debt = 6.65% (1 0,30) = 4.66%
Vd = $1,000,000 110/100 = $1.1m
Therefore, WACC = (6.1 / 7.2) 16% + (1.1 / 7.2) 4.66% = 14.3%