You decided to use the Fama-French 3-factor model to compute the cost of equity for Pear...

Transcribed Image Text:

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 + BM[rM.T - rft] + BSMB [rSmall,t "Big,t] + BHML[r High B/M,t Low B/M,t] + t Your estimates for BM, BSMB and BHML 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[rRMRF] +BSMBE[r SMB] + PHMLE[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 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 + BM[rM.T - rft] + BSMB [rSmall,t "Big,t] + BHML[r High B/M,t Low B/M,t] + t Your estimates for BM, BSMB and BHML 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[rRMRF] +BSMBE[r SMB] + PHMLE[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)

To calculate the cost of equity and aftertax Weighted Average Cost of Capital WACC for Pear Corporation using the FamaFrench 3factor model we need to ... View the full answer