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21 October, 05:49

Auto Parts is considering a merger with Car Parts. Car Parts market-determined beta is 0.9, and the firm currently is financed with 20% debt, at an interest rate of 8%, and its tax rate is 25%. If Auto Parts acquires Workman, it will increase the debt to 60%, at an interest rate of 9%, and the tax rate will increase to 35%. The risk-free rate is 6% and the market risk premium is 4%. What will Car Parts required rate of return on equity be after it is acquired?

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  1. 21 October, 05:53
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    Answer: 9.7%

    Explanation:

    Given Data

    Rf = Risk free return = 6%,

    Rpm = Risk premium = 4%,

    Beta = 0.9

    Wd = Debt = 20%

    rd = cost of debt = 8%

    We = equity = 80%

    Re = Rf + Beta (Rpm)

    = 0.06 + 0.9 (0.04)

    = 0.096 * 100

    = 9.6%

    Unlevered Equity Cost;

    ReU = Wd * rd + We * re

    = 0.20 * 8% + 0.80 * 9.6%

    = 9.28%

    Levered Equity Cost:

    New Debt = 60%,

    New Equity = 40%,

    New rd = 9%

    ReL = ReU + (ReU - rd) (D : E)

    = 9.28% + (9.28% - 9%) (0.60 : 0.40)

    = 0.097 * 100

    = 9.7%
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