Question

1. JP Inc. is a small company in the business of producing and selling musical CDs and cassettes and it is also involved in promoting concerts. JP`s stock has been listed on the NASDAQ for the last two years and is trading at twice the book value of equity. (The book value of equity is $120M). JP derives 75% of its total market value from its record/CD business and 25% from the concert business. While the price data on the company is insufficient to estimate a beta, the beta of comparable firm in these businesses is as follows.

Business	Average asset beta
Record/CD	0.88
Concert Business	1.13

The debt is composed of ten year bonds of 60M at maturity with annual coupon payment of 5M per year and is rated A (typical A rated bonds are yielding 10% currently in the market). The current risk free rate is 8% and market risk premium is 5.5%. Assume no corporate taxes

1. Estimate the current cost of equity?
2. Estimate the current weighted average cost of capital?

b. 18.36%

c. 18.78%

d. 6.40%

Answer 1

GIVEN THAT :-

According to the question we have that ,

JP Inc. is a small company of producing and selling musical CDs and cassettes .

JP derives 75% of its total market value from its record/CD business and 25% from the concert business

Record/CD ( bussiness)

0.88    (aveg asset beta)

Concert Business (bussiness)

1.13 (avge asset beta)

TO FIND :-a)Estimate the current cost of equity?

for finding the cost of equity we need to find first weighted average of the divisions beta

weighted average of divisions beta =75%*0.88+25%*1.13

=0.66+0.2825

=0.9425

for finding the cost of equity we have a formula

cost of equity = risk free + beta * market risk premium

substituting the values we get that

==> 8%+0.9425*5.5%

calculating this we get that

0.13183

converting it in to the percentage we get

13.18%

therefore,

the current cost of equity = 13.18%

TO FIND :-b)Estimate the current weighted average cost of capital?

presenet value of bonds =

===> 5M/0.1*(1-1/1.1^10)+60M/1.1^10

solving the above we get that

=$53.85543M

finding the market value of equity = $120M*2

= $240M

finding the weight of the equity = 240/(240+53.85543)

= 240/(293.85543)

=0.81672

finding the weight of the debt = 1- 0.18672

= 0.18327

so

for finding the   weighted average cost of capital we have a formula

==> weight of debt *cost of debt + weight of equity * cost of equity

substituting the values we get that,

= 0.18327*10%+0.81672*13.18%

by solving the above we get that

=0.018327+0.107643

= 0.125970

converting it in to percentage

12.59%

there fore,

the current weighted average cost of capital =12.59%

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