Question

3. Intermountain Resources Inc. has three divisions with the following equity betas: Proportion Division Beta of Assets Lumber 0.7 X 50% Coal 1.2 X 30% Tourism 1.3 X 20% The risk free rate is 7% and the market risk premium is 8%. The firm's debt costs 7.6% per year. Its tax rate is 25% a) What is Intermountain's cost of equity? b) If the firm uses 40% equity and 60% debt, what is the WACC? E c hare This is ynected to arow at an 9%

Answer 1

a

Weight of Lumber = 0.5

Weight of Coal = 0.3

Weight of Tourism = 0.2

Beta of Firm = Weight of Lumber*Beta of Lumber+Weight of Coal*Beta of Coal+Weight of Tourism*Beta of Tourism

Beta of Firm = 0.7*0.5+1.2*0.3+1.3*0.2

Beta of Firm = 0.97

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 7 + 0.97 * (8)

Expected return% = 14.76

\

b

Weight of equity = 1-D/A

Weight of equity = 1-0.6

W(E)=0.4

Weight of debt = D/A

Weight of debt = 0.6

W(D)=0.6

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 7.6*(1-0.25)

= 5.7

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=5.7*0.6+14.76*0.4

WACC =9.32%