Question

5. Altria is reexamining the costs of capital it uses to decide on investments in its two
primary businessesó food and tobacco. The two divisions have about the same market
value.
Altria has an equity beta of 0.95 and a debt/equity ratio of 25%. The companyís debt is
priced to yield an expected return of 8%. The average equity beta of publicly traded Örms
in the tobacco business is 1.2, the average debt beta is 0.3, and the average debt/equity
ratio of such Örms is 20%. The average equity beta of publicly traded Örms in the food
business is 0.9, the average debt beta is close to zero, and the debt/equity ratio of such
Örms is 80%. The current interest rate is 7.1%.
Estimate the cost of capital for each of the two businesses

Answer 1

Using the information for publicly traded firms in the tobacco business, the asset beta for Altria’s tobacco division should be.

  =1/6 (0.3) + 5/6(1.20 = 1.5

Similarly, using the information for publicly traded firms in the food business, the asset beta for altria’s food division should be.

= 4/9(0) + 5/9(0.9) =0.50

To estimate the cost of capital for the two divisions, we now need to figure out what is the expected rate of return on the market portfolio. This can be done as follows. The asset beta for altria’s as a whole is.

BA =1/2 + 1/2 = 1/2 (1.05) + 1/2(0.50) = 0.775

Since Philip Morris has a 25% debt/equity ratio, we must have.

   = 1/5 + 4/5 : 0.775 =1/5 + 4/5 90.95) := 0.075

In turn, this implies

rD = rf + (rm - rf ) : 0.08=0.071 + (rm - 0.071)(0.075)

Solving for the expected rate of return on the market portfolio gives rm= 0.191. The cost of capital for the tobacco division is then given by

rTA = rf + (rm - rf ) = 0.071 + (0.191 - 0.071)(1.500 = 0.197

while the cost of capital for the food division is given by

rfa = rf+ (rm - rf)   = 0.071 = (0.191 - 0.071) (0.50) = 0.131