Question

Your firm is planning to invest in an automated packaging plant. Harburtin Industries is an​ all-equity firm that specializes in this business. Suppose​ Harburtin's equity beta is 0.85​,the​ risk-free rate is4%​,and the market risk premium is 5%.

a. If your​ firm's project is​ all-equity financed, estimate its cost of capital.After computing the​ project's cost of capital you decided to look for other comparables to reduce estimation error in your cost of capital estimate. You find a second​ firm, Thurbinar​ Design, which is also engaged in a similar line of business. Thurbinar has a stock price of$20per​ share, with 15 million shares outstanding. It also has $100 million in outstanding​ debt, with a yield on the debt of 4.5%. ​Thurbinar's equity beta is 1.00.

b. Assume​ Thurbinar's debt has a beta of zero. Estimate​ Thurbinar's unlevered beta. Use the unlevered beta and the CAPM to estimate​ Thurbinar's unlevered cost of capital.

c. Estimate​ Thurbinar's equity cost of capital using the CAPM. Then assume its debt cost of capital equals its yield and using these​ results, estimate​ Thurbinar's unlevered cost of capital.

d. Explain the difference between your estimate in part​ (b​) and part ​(c​).

e. You decide to average your results in part ​(b​) and part ​(c​), and then average this result with your estimate from part ​(a​). What is your estimate for the cost of capital of your​ firm's project?

Answer 1

a) cost of capital using CAPM - 8.25%

b) Unlevered cost of capital - 7.75%

c) Unlevered cost of capital if the cost of debt is yield will be - 7.875%

d) difference between b and c only due to cost of debt.

e) average of b and c will be 7.8125%.