Question

Beta company is a publicly traded company, with 20 million shares trading at $ 70 a share and $ 600 million in debt (market value as well as book value) outstanding. The firm derives 70% of its value from cloud storage and hosting, and the remaining 30% from technical service. The unlevered beta is 0.8 for firms in the cloud business and 1.2 for firms in the technical service business. Beta company is rated A and can borrow money at 5%. The risk-free rate is 2% and the market risk premium is 8%; the corporate tax rate is 30%, and the firm has a capital gains tax rate of 20%.

1. Estimate the cost of capital for Beta Company

2. Beta Company is considering acquiring Alpha Company, another cloud hosting company (which derives 100% of its revenues from hosting) for $ 350 million, three quarters of which it plans to fund by a new debt issue (which will cause its rating to drop and its cost of debt to rise to 5.5%) and a quarter by issuing new stock. Estimate the cost of capital after the acquisition.

Answer 1

1. Cost of capital = Cost of Equity * Equity/Total + Cost of Debt * Debt/Total

Particulars	Calculation	Amount	Ratio
Equity share	20*1000000*70	1,40,00,00,000.00	0.7
Debt	600*1000000	60,00,00,000.00	0.3
Total		2,00,00,00,000.00

Cost of Debt = Interest Rate *1- Tax Rate

= 5 * (1-0.3)

= 3.5%

Cost of Equity = Risk free rate + Beta (Risk Premium)

Levered beta should be used to calculate Cost of Equity

Levered beta = Unlevered Beta * (1+(1-Tax rate)*Debt to Equity Ratio)

Unlevered Beta for the company is calculated as % of revenue derived * Concern Beta

% of Revenue	Unlevered Beta	Mean
a	b	c=a*b
0.7	0.8	0.56
0.3	1.2	0.36
		0.92

We need to use Capital Gains Tax Rate here to arrive at Levered Beta.

Levered beta = 0.92 *(1+(1-0.2)*0.3/0.7

= 1.196

Cost of Equity = 2% + 1.196(8%)  

= 11.568%

Cost of capital = Cost of Equity * Equity/Total + Cost of Debt * Debt/Total

= 11.568%* 0.7+ 3.5%*0.3

= 9.15%