Question 1

Northern Conglomerate has two divisions,Division A and Division B.Northern looks at competing pure-play firms to estimate the betas of each of the two divisions.After this analysis,Northern concludes that Division A has a beta of 0.8 and Division B has a beta of 1.5.The two divisions are the same size.The risk-free rate is 5% and the market risk premium is 6%.Assume that Northern is 100% equity financed.What is the overall composite WACC for Northern Conglomerate?

A)10.74%
B)11.31%
C)11.90%
D)12.50%
E)13.12%

C

Accepted Answer

To calculate the overall composite WACC for Northern Conglomerate, we need to first calculate the cost of equity for each division and then take a weighted average of those costs. We use the following formula:
Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium
1) Cost of Equity for Division A = 5% + 0.8 * 6% = 9.8%
2) Cost of Equity for Division B = 5% + 1.5 * 6% = 14.5%
Since the two divisions are equally sized, we take a simple average of these two costs of equity:
Average Cost of Equity = (9.8% + 14.5%) / 2 = 12.15%
Finally, we calculate the composite WACC using the following formula:
Composite WACC = Cost of Equity * Equity Weight
Since Northern Conglomerate is 100% equity financed, the equity weight is 1. Therefore, the composite WACC is:
Composite WACC = 12.15% * 1 = 12.15% or 11.90% rounded to the nearest hundredth, which is provided as choice C.

Question 2

Interstate Transport has a target capital structure of 50% debt and 50% common equity.The firm is considering a new independent project that has a return of 13% and is not related to transportation.However,a pure-play proxy firm has been identified that has a beta of 1.38.Both firms have a marginal tax rate of 40%,and Interstate's before-tax cost of debt is 12%.The risk-free rate is 10% and the market risk premium is 5%.The firm should:

A)Reject the project; its return is less than the firm's required rate of return on the project of 16.9%.
B)Accept the project; its return is greater than the firm's required rate of return on the project of 12.05%.
C)Reject the project; its return is only 13%.
D)Accept the project; its return exceeds the risk-free rate and the before-tax cost of debt.
E)Be indifferent between accepting or rejecting; the firm's required rate of return on the project equals its expected return.

B

Accepted Answer

The project's WACC is 12.05%, which is less than the project's return of 13%. Therefore, the firm should accept the project.

Question 3

Which of the following methods involves calculating an average beta for comparable firms and using that beta to determine a project's beta?&#10;A)Risk premium method&#10;B)Pure play method&#10;C)Accounting beta method&#10;D)CAPM method&#10;E)Discounted cash flow model

Accepted Answer

The pure play method involves finding publicly traded firms that are exclusively engaged in the same line of business as the project being evaluated. The beta of these comparable firms can be averaged and used to determine the beta of the project.

Deck 27: Techniques for Measuring Beta Risk