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 is 4%​, 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 $20 per​ 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