It is 5pm on 27th April 2016. You are an intern with an investment fund and working hard to support your colleagues on various tasks. You are keen to demonstrate skills acquired from your finance course to increase the chance to be offered a permanent position. A colleague, Sanjay, is building a model to value Meridian Energy and needs your help to estimate the weighted average cost of capital (WACC). Common practice in this fund is to estimate beta by regressing 5-year monthly total returns to a stock on the monthly total returns to the NZX All index portfolio. However, Meridian has been listed for less than five years. Sanjay suggests that you estimate the equity beta of Contact Energy and use it to derive Meridian’s equity beta. Handing over a dataset that contains the adjusted closing prices of Contact Energy and the levels of NZX AllIndices at the monthly frequency over the past 5 years (see worksheet “Q1” in the Excel file FIN351_2016FC_Assignment2_Data.xlsx), Sanjay asks you to come up with the WACC estimation for Meridian and supply him the sources of information and workings. You are keen to prove that you can work independently on this task.

(1) Contact Energy’s Equity Beta. (5 marks).The Excel file contains three time series. They are adjusted closing prices on 27thof each month of Contact Energy,the NZX All price index and the NZX All total return indexover the past five years, sourced from Datastream. Both the adjusted closing price series and the total return index series include dividends declared during each period. Choose the correct index series to derive the return to the market portfolio, as well as deriving the total return to holding Contact Energy shares. Then, estimate the equity beta of Contact Energy using two different methods. Method one is regression analysis. Method two is fitting a straight line on a plot chart with the equation showing. Print out the regression output and the plot chart and attach them to your solution as Appendix 1(1).Record your answers to four decimal places. Write down your final answer in the cell below.

Contact Energy’s Equity Beta

(2) Meridian Energy’s Equity Beta (15marks).Go to “Yahoo! New Zealand Business & Finance” (https://nz.finance.yahoo.com/) and search for information that you can use to un-lever the beta of Contact Energy and re-lever it to obtain Meridian Energy’s equity beta. The tickers for these two firms are CEN.NZ and MEL.NZ. Estimating Meridian Energy’s equity beta involves four main steps. First, obtaining the market capitalisation of each firm as of 27th April. You need to input the ticker of each firm in the “Look Up” box and click enter to go to the main Yahoo!Finance web page of each firm. Click on “Historical Prices” on the left hand side of the page and obtain the closing price (“Close”) on 27th April 2016. Click on “Key Statistics” on the left hand side of the page and obtain total number of shares outstanding from the right-hand-side of the page (“Shares Outstanding”). Second, obtain the book value of net debts from the most recent balance sheets. Third, un-lever the beta of the comparable company (CEN.NZ in this case) to obtain the asset beta. Fourth, re-level the industry asset beta to the leverage ratio of company that you are valuing to obtain its equity beta. Record your answer in the table below. Show your answers to debt ratios and betas to four decimal points and other answers to two decimal points.

CEN.NZ MEL.NZ

Closing Price on 27th April 2016(NZD)

Shares Outstanding (NZD million)

Market Capitalisation (NZD million)

Latest balance sheet date

Short/Current Long Term Debt (NZD million)

Long Term Debt (NZD million)

Cash and Cash Equivalent (NZD million)

Net Debt (NZD million)

E/(D+E) (using net debt and market cap.)

D/E (using net debt and market cap.)

Equity beta

Asset beta

(3) Cost of Equity of Meridian Energy (5 marks). Assume that the risk premium for New Zealand stock market is 5% p.a.. Go to the NZX debt market website for all traded bonds (https://www.nzx.com/markets/nzdx/bonds) to obtain New Zealand risk-free rate as of 27th April. Scroll down the window to find the government bond with the longest maturity (GOV410). Access the link to this bond, scroll down the window and click on the button “Load interactive chart” on the chart titled “Yield History”. Now you can slide the red line across the chart to obtain the yield on 27th April. Record this yield as the risk-free rate. Apply the capital asset pricing model to estimate the cost of equity of Meridian Energy.

Meridian Energy’s Equity Beta

NZ Market Risk Premium

Risk free rate (government stock yield)

Estimate date 27th April 2016

Cost of equity

(4) Cost of Debt of Meridian Energy (2 marks).Assume that if Meridian Energy issues a bond with 10-year maturity now, the bond will have a rating of BBB+. Assume that a NZ$BBB+ bond with 10-year maturity has a spread of 115 bps over the government stock. Estimate the cost of debt of Meridian Energy.

Estimate date 27th April 2016

Cost of debt

(5) WACC of Meridian Energy (3 marks). Use the information from previous steps and assume the corporate marginal tax rate to be 28% to estimate the after-tax WACC for Meridian Energy. Show your workings and final answer below:

Workings:

Final Answer (show your answer in percentage with two decimal points): …………………..