You are trying to evaluate whether Adam plc, a UK based firm, has excess debt capacity. In 2019, Adam plc had 12.2 million shares outstanding at 21,000p per share and debt outstanding at £3 billion (book as well as market value). The debt has a rating of B and carries a cost of debt of 10.12%. In addition, the firm had leases outstanding, with annual lease payments anticipated to be £150million. The beta of the stock is 1.26. The risk-free rate is 6.12%. The market risk premium is 5.5%. (a) Estimate the current debt ratio for Adam plc. (b) Estimate the current cost of capital. (c) Estimate the current weighted average cost of capital (WACC). (d) Based on the 2019 operating income, the optimal debt to total capital ratio is computed to be 30%, at which point the rating will be BBB, and the new cost of debt is 8.12%. Estimate the WACC.
You are trying to evaluate whether Adam plc, a UK based firm, has excess debt capacity. In 2019, Adam plc had 12.2 million shares outstanding at 21,000p per share and debt outstanding at £3 billion (book as well as market value). The debt has a rating of B and carries a cost of debt of 10.12%. In addition, the firm had leases outstanding, with annual lease payments anticipated to be £150million. The beta of the stock is 1.26. The risk-free rate is 6.12%. The market risk premium is 5.5%.
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(a) Estimate the current debt ratio for Adam plc.
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(b) Estimate the current cost of capital.
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(c) Estimate the current weighted average cost of capital (WACC).
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(d) Based on the 2019 operating income, the optimal debt to total capital ratio is computed to be
30%, at which point the rating will be BBB, and the new cost of debt is 8.12%. Estimate the
WACC.
*Below are the solutions to the above questions, but I am unsure on part c and d, as to how they found those numbers for the WACC- any help would be much appreciated!
(Answers)
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Current market value of equity=12.2(210) =£2562.
If we capitalise the lease payments at the same rate as debt, we get a PV of 150/0.1012=1,482. The market value of the debt itself is £3,000.
Hence, the debt to equity ratio is = (3000+1482)/2562=1.75 or a debt ratio of 0.6364. -
b) The
cost of equity = 0.0612+1.26(0.055) =0.1305 -
c) WACC=0.6364(1-0.19)10.12%+(0.3636)13.05%=9.962%
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d) The current beta is 1.26:
the unlevered beta=1.26/(1+(1-0.35)1.75=0.5212.
Hence the levered beta at a debt ratio of 30%=0.5212(1+(1-0.19) (0.3/0.7) =0.70213. The cost of equity =0.0612+0.70213(0.055) =0.0998.
WACC= (0.3) (1-0.19) (0.0812) +(0.7) (0.0998) =8.959%
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