Question

CCost of Debt = 2%

Sun Solar has earnings before interest and taxes of $106 million and considering making a change to its capital structure to reduce its cost of capital and increase firm value. Right now, Sun is all equity with unlevered cost of capital of 12 % based on CAPM. The risk- free rate is 6%, the market risk premium (MRP=RM - RRF) of 5% and tax rate of 40%. 1. What would be Sun's estimated levered cost of equity and cost of capital if it were to change its capital structure to the industry average in Table 1? 2. According to Table-2? Market Table 1- Solar Industry Peers Net Income Сар P/S Interest D/E stock price 37.95 Mil Coverage Mil 1,632 SolarEdge Technologies Inc 67.96 7,137 -425 -22 First Solar Inc (USD) SunPower Corp (USD) JinkoSolar Holding Co Ltd (USD.CNY) 8.51 24.47 1,211 804 -8.3 - 0.8 19.5 648 1.3 0.7 587 Sunrun Inc (USD) Hanwha Q CELLS Co Ltd (USD) Vivint Solar Inc (USD) JA Solar Holdings Co Ltd (USD.CNY) 5.89 7.2 3.95 7.47 -557 1,118 0.2 941.3 220.3 4512 0.1 -100 0.1 51 0.7 0. 9 1.2 0.8 0.3 6 .9 - 10.3 4. 1 3.3 -5.9 4 1.5 0.3 2.7 3.8 - 2.2 2.76 Rene Sola Ltd (USD) Greatcell Solar Ltd (USD,AUD) Vivopower International PLC (USD) 0.1 0 -185. 11 19.8 59.6 0.7 0.3 1.07 24 0.3 0.1 Sunworks Inc (USD) Industry Average 1.3 1.4 -153 355 - - -8.1 44.6 0.7 Bond Before-tax Percent financed Table 2 Percent financed with debt (Wa) with equity (WE) Rating cost of debt 0.9 AAA 7.00% 0.8 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.6 0.5 0.4 ААТ ΑΙ BBB BB | B 7.20% 8.00% 8.80% 9.60% 11.00%

Answer 1

1). Unlevered cost of equity (RsU) = Rf + beta*Rmp where Rf (risk-free rate) = 6%; Rmp (market risk premium) = 5%

Unlevered beta = (RsU - Rf)/Rmp = (12%-6%)/5% = 1.20

Levered beta = unlevered beta*[1 + (1-Tax rate)*D/E] = 1.20*[1 + (1-40%)*0.6] = 1.63

Levered cost of equity (RsL) = Rf + beta*Rmp = 6% + (1.63*5%) = 14.16%

Cost of capital = (We*RsL) + (Wd*Rd*(1-Tax rate)) where

We (weight of equity) = 1/(1+D/E) = 1/(1+0.6) = 0.625; Wd (weight of debt) = 1- Wd = 1-0.625 = 0.375; Rd (cost of debt) = 2%

Cost of capital = (0.625*14.16%) + (0.375*2%*(1-40%)) = 9.30%

b).

Formula				Rd*(1-T)			bu*[1 + (1-T)*Wd/We]	Rf + (B*Rmp)	(Wd*After-tax cost of debt)+(We*RsL)
Percent financed with debt (Wd)	Percent financed with equity (We)	Bond rating	Before-tax cost of debt (Rd)	After-tax cost of debt	Unlevered cost of quity (RsU)	Unlevered beta (bu)	Levered beta (B)	Levered cost of equity (RsL)	WACC
0.1	0.9	AAA	7.00%	4.20%	12.00%	1.20	1.28	12.40%	11.58%
0.2	0.8	AA	7.20%	4.32%	12.00%	1.20	1.38	12.90%	11.18%
0.3	0.7	A	8.00%	4.80%	12.00%	1.20	1.51	13.54%	10.92%
0.4	0.6	BBB	8.80%	5.28%	12.00%	1.20	1.68	14.40%	10.75%
0.5	0.5	BB	9.60%	5.76%	12.00%	1.20	1.92	15.60%	10.68%
0.6	0.4	B	11.00%	6.60%	12.00%	1.20	2.28	17.40%	10.92%