Question

2. (20 Marks) China Holdings (CH) has an capitalization of $10.8 billion, and an enterprise value of $14.4 billion. In addition, CH has a debt cost of capital of 6.1 % and its marginal tax rate is 35% equity cost of capital of 10 % , a market a. (5 marks) Briefly explain the difference between a company's WACC and its expected return on equity. Give an example of where you would use a company's WACC to discount future cash flows. Give an example of where you would use a company's expected return flows on equity to discount future cash b. (5 marks) What is China Holdings WACC? (10 marks) If China Holdings maintains a constant debt-to-equity ratio, what is the net present value of a project with the following expected free cash flows (FCF)? The risk of this project's FCF is the same as the risk of China Holdings other assets. c. 2 3 FCF -100 50 100 70

Answer 1

a) A company's WACC is the weighted average cost of capital and includes the impact of debt on its capital structure. In case the company uses debt funding and equity to finance a project, then WACC should be used. If only equity funds are used, then expected return on equity should be used Value b) Post tax cost 10.00% Equity 10.8 Debt 3.97% 3.6 Total 14.4 WACC 8.49% c) FCF Cash Flow NPV @ WACC Year 85.86 0 -100 1 50 100 70