You are trying to estimate the value of Pear Corporation using the WACC approach. As a...

 

 

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You are trying to estimate the value of Pear Corporation using the WACC approach. As a first step, you decided to estimate the company's cost of debt. While the company's current D/V is 0.20, you noticed that the company is expected to approximately double its D/V ratio next quarter. Therefore, you decided to work with a target D/V ratio equal to 0.40. You also noticed that the current rating of the company's debt is A and that this rating is expected to be downgraded to BBB- as a consequence of the expected increase in leverage. Therefore, you expect the company to have a BBB- rating from next quarter on. This motivated the collection of the information below. U.S. Government Debt (Treasuries) Maturity 1 Year 30 Years 2.70 4.30 0.55 3.10 Historical Average Yield Current Yield Corporate Debt (A- Rating) Maturity 1 Year 30 Years Historical Average Spread 1.20 2.30 Current Spread 0.90 1.10 Corporate Debt (BBB- Rating) Maturity 1 Year 30 Years Historical Average Spread Current Spread 1.50 2.70 1.10 1.80 Note: All numbers above are in percentage points. The spread for the corporate debt is computed as the difference between the yields and the risk-free rate of same maturity. 1. Estimate the cost of debt for Pear Corporation (Hint: the cost of debt equals the risk-free rate plus a credit-risk spread following the planned levering up. The cost is based on current long-term rates). You decided to use the Fama-French 3-factor model to compute the cost of equity for Pear Corporation. As a first step in your analysis, you download historical data on the returns and estimate the following time-series regression: - (rit rft): = a + B[rMT ft] + B'SMB [r small,t- Big.t]+BHML [High B/M,t - "Low B/M,t] + Et Your estimates for ẞм, ẞSMB and ẞHML for Pear Corporation were 0.95, 0.43 and 0.25, respectively. The debt-to-value ratio of the company over the estimation period of your regression is 0.20. The Fama-French 3-factor model is given by: E(r) = r; + BME[r RMRF] + ß'sMBE[rsMB] + BHMLE[THML] You also decide to make the following additional assumptions: (i) Risk-free rate given by previous table (U.S. Treasuries). (ii) Market minus Risk-free Risk-premium =E[RRMRF]=5.00%; Small-minus-Big Risk-premium= E[RSMB] 4.50%; High B/M-minus-Low B/M Risk Premium =E[RHML]=3.60% (These are the expected return on each of the 3 risk factors, where the latter are represented by 3 zero-cost long-short portfolios). (iii) Company's debt beta = 0 (for all betas; meaning the debt is not sensitive to any of those risk factors). (iv) Target debt-to-value ratio for the company in the future (as previously described): 0.40. (v) Tax rate 40%. 2. Based on this approach, what is the cost of equity and after-tax WACC for the company at the target debt-to-value ratio? (Hint: un-lever and re-lever each of the single equity betas, then use the three re-levered equity betas to calculate firm's cost of equity based on the Fama-French 3-factor model. Then simply calculate the after-tax WACC). You are trying to estimate the value of Pear Corporation using the WACC approach. As a first step, you decided to estimate the company's cost of debt. While the company's current D/V is 0.20, you noticed that the company is expected to approximately double its D/V ratio next quarter. Therefore, you decided to work with a target D/V ratio equal to 0.40. You also noticed that the current rating of the company's debt is A and that this rating is expected to be downgraded to BBB- as a consequence of the expected increase in leverage. Therefore, you expect the company to have a BBB- rating from next quarter on. This motivated the collection of the information below. U.S. Government Debt (Treasuries) Maturity 1 Year 30 Years 2.70 4.30 0.55 3.10 Historical Average Yield Current Yield Corporate Debt (A- Rating) Maturity 1 Year 30 Years Historical Average Spread 1.20 2.30 Current Spread 0.90 1.10 Corporate Debt (BBB- Rating) Maturity 1 Year 30 Years Historical Average Spread Current Spread 1.50 2.70 1.10 1.80 Note: All numbers above are in percentage points. The spread for the corporate debt is computed as the difference between the yields and the risk-free rate of same maturity. 1. Estimate the cost of debt for Pear Corporation (Hint: the cost of debt equals the risk-free rate plus a credit-risk spread following the planned levering up. The cost is based on current long-term rates). You decided to use the Fama-French 3-factor model to compute the cost of equity for Pear Corporation. As a first step in your analysis, you download historical data on the returns and estimate the following time-series regression: - (rit rft): = a + B[rMT ft] + B'SMB [r small,t- Big.t]+BHML [High B/M,t - "Low B/M,t] + Et Your estimates for ẞм, ẞSMB and ẞHML for Pear Corporation were 0.95, 0.43 and 0.25, respectively. The debt-to-value ratio of the company over the estimation period of your regression is 0.20. The Fama-French 3-factor model is given by: E(r) = r; + BME[r RMRF] + ß'sMBE[rsMB] + BHMLE[THML] You also decide to make the following additional assumptions: (i) Risk-free rate given by previous table (U.S. Treasuries). (ii) Market minus Risk-free Risk-premium =E[RRMRF]=5.00%; Small-minus-Big Risk-premium= E[RSMB] 4.50%; High B/M-minus-Low B/M Risk Premium =E[RHML]=3.60% (These are the expected return on each of the 3 risk factors, where the latter are represented by 3 zero-cost long-short portfolios). (iii) Company's debt beta = 0 (for all betas; meaning the debt is not sensitive to any of those risk factors). (iv) Target debt-to-value ratio for the company in the future (as previously described): 0.40. (v) Tax rate 40%. 2. Based on this approach, what is the cost of equity and after-tax WACC for the company at the target debt-to-value ratio? (Hint: un-lever and re-lever each of the single equity betas, then use the three re-levered equity betas to calculate firm's cost of equity based on the Fama-French 3-factor model. Then simply calculate the after-tax WACC).

Answer rating: 100% (QA)

1 Cost of Debt for Pear Corporation Since Pear Corporations debt rating is expected to downgrade to BBB after the planned increase in leverage we will ... View the full answer