Question

Q4) a) Ibrahim and his sons (Ibrahim & Sons) have been operating an excavation company in British Columbia for the last 15 years. The company has been successful in generating revenue and free cash flows (FCF). The company is planning to replace 5 excavators. The supplier will trade in old excavators and will deduct $100,000 from the total purchase price of new excavators. Each new excavator will cost $165,000. The corporate tax rate is 35%. The company beta (BA) is 2.45, risk-free return (Rt) is 1.45%, and the risk premium is 6%. Based on the risk, the bank will charge 7.50% on the commercial loans/chattel mortgages granted for excavators. The company will use 46% equity financing and 54% debt financing. Based on the above information, please calculate the WACC. Please show all the calculations by which you came up with the final answer. (3 Points) Answer: b) Another excavation company called Diamond 15 has 30,000 shares of common stock outstanding with a market price of $200 per share. It has 3,000 bonds outstanding, each selling for $1,200. The bonds mature in 15 years, have a coupon rate of 6.50%, and pay coupons annually. The firm's beta is 1.94, the risk-free rate is 1.45%, and the market risk premium is 4.50%. The tax rate is 34%. Based on the above information, please calculate the WACC. Please show all the calculations by which you came up with the final answer. (3 Points) Answer: c) Based on your analysis and findings (Questions: a & b), which company has higher risk (Ibrahim & Sons or Diamond 15) and higher cost of capital? Why? How would you define business and financial risk? Where do business and financial risk come from? Please explain your reasoning. (2 Points)

Answer 1

4. a) Cost of Equity (ke) = Risk-Free Rate + (Beta * Risk Premium)
= 1.45% + 2.45*6%
= 1.45% + 14.7%
= 16.15%
Cost of Debt (kd) = Interest Rate on Loan * (1 - Tax Rate)
= 7.5% * (1 - 0.35)
= 4.875%
WACC = Weightage of equity * ke + Weightage of Debt * kd
= 0.46 * 16.15% + 0.54 * 4.875%
= 7.429% + 2.6325%
WACC = 10.0615% ~ 10.06%

4. b) Cost of Equity (ke) = Risk-Free Rate + (Beta * Risk Premium)
= 1.45% + 1.94*4.5%
= 1.45% + 8.73%
= 10.18%
YTM of the bond =  4.6221%
   Cost of Debt (kd) = YTM of the bond * (1 - Tax Rate)
= 4.6221* (1-0.34)
= 3.0506%
Market Value of Equity = 30,000 * 200 (No of shares * price per share)
= $6,000,000
Market Value of Debt = 3,000 * 1,200 (No of bonds * Mkt value per bond)
= $3,600,000
Market Value of Total Capital = $6,000,000 + $3,600,000
= $9,600,000
Weightage of Equity = 6,000,000/9,600,000 = 0.625 or 62.5%
Weightage of Debt = 1 - weightage of equity = 1-0.625 = 0.375 or 37.5%

WACC = Weightage of equity * ke + Weightage of Debt * kd
= 0.625 * 10.18% + 0.375 * 3.0506%
= 6.3625% + 1.143975%
WACC = 7.506475% ~ 7.51%

c) Ibrahim & Sons has higher risk and higher cost of capital (higher WACC) because Ibrahim and Sons has more debt as % of total capital (54%) as compared to that of Diamond 15 (37.5%)

Business Risk:
Business Risk can be defined as risk where the company makes lower profits or makes losses too. Factors that affect business risk are lower selling price, higher costs, competition, lower demand, etc.
Financial Risk:
Financial Risk is the risk that the company might not be able to pay back its due or debt obligations. Factors that affect financial risks are high debt, higher interest costs, cashflow mismanagement, etc.