Explanation of the Wacc – Testing Hypothesis
Explanation of the WACC
The two pure play comparable firms are Brunswick Chemical and Southern Chemicals. Both of these firms specialized in the production of sodium chlorate. Therefore the two firms are great comparables to obtain the asset beta. The equity betas are given in Exhibit 5 of the case. The average equity beta for Brunswick and Southern is 1.15. The average E/V ratio of the two companies was used to delever the equity beta. The resulting unlevered beta is .9415. Since the assumption was that debt changes to maintain a constant D/V ratio, Eq. 1 was used:
β_OA= E/(D+E) ×β_E……………………………………………1
Dollar amounts are in thousands
Next the asset beta needed to be relevered for the project. The asset beta was relevered with the E/V ratio of Dixon after the project was executed. The current debt and equity of Dixon was taken from Exhibit 7 (D = $1,000, E = $14,718). The project added $8,000 of debt and $4,000 of equity to Dixon. This resulted in a E/V ratio of $18,718/$27,718 = .675. The re-levered equity beta is 1.39.
Now the CAPM will be used to calculate the cost of equity. We estimate the market risk premium at 7% for 1979. The risk free rate was assumed to be the return of long-term treasury bonds, which was 9.5%. The final result for the cost of equity is 19.26%. The cost of equity is the interest rate that Dixon is able to go out on the market and raise. Since Dixon received and interest rate of 11.25%, this was assumed to be the cost of debt. The debt and equity used in the WACC calculation is equal to the debt and equity used to re-lever the equity beta, which was D = $9,000 and E = $18,718. The tax rate was calculated from the Dixon financial statements in Exhibit 7, which was surprisingly high at 48%. The WACC is 14.9%.
All-equity cost