Question

The CEO of FUN Corp. believes the cost of capital used in the previous question is inaccurate. You have been assigned to estimate cost of capital for FUN Corp.

• The company has a capital structure which consists of 80% long-term debt and 20% common stock.
• The company’s credit rating is Ba1/BB+ (equivalent to spread of 2%). Beta of debt is 0.
• The company’s common stock currently sells for $35 per share with 2.5 million shares outstanding.
• The company’s marginal tax rate is 30%. Market risk premium is 5%. Risk-free rate is 5%.
• FUN Corp.’s most comparable competitor is Toy Inc. who has no debt. Toy Inc’s equity beta is 1.4.

Answer the following questions (please show reasonings or calculations):

1. What is Toy Inc’s cost of capital?
2. What is FUN Corp’s cost of capital?

Answer 1

a. Toy Inc's Cost of Capital:

Toy Inc is the most comparable competitor for FUN Corp

Hence we can consider that the Market risk premium for Toy Inc as 5%.

Risk-free rate (RFR) = 5%

Using the Capital Asset Pricing Model (CAPM), we can calculate the Cost of Equity (Ke) for Toy Inc.

Beta = 1.4

Ke = RFR + Beta*Risk premium

= 5% + 1.4 * 5% = 0.05+(1.4*0.05) = 0.05+0.07 = 0.12

Ke = 12%

Weighted Average Cost of capital, WACC = we*Ke + wd*Kd*(1-t), where t is the marginal tax rate of the company, we & wd are weights of Equity & Debt respectively and Kd is the cost of debt.

Since Toy Inc has no debt, wd*Kd = 0

WACC = we*Ke = 1 * 12% = 12%

b. FUN Corp's Cost of Capital:

Since Toy Inc is the most comparable competitor for FUN Corp, we can find the Equity beta of FUN corp using the Equity beta of Toy Inc.

First we need to find the unlevered beta from the equity beta of Toy Inc

Unlevered Beta = Competitor's beta / [1+(D/E)*(1-t)]

Since Toy Inc has no debt, unlevered beta (Asset Beta) = competitor's beta = 1.4

Then we can find the levered beta using the formula,

Levered Beta = Unlevered Beta * [1+(D/E)*(1-t)] = 1.4*[1+ (.8/.2)*(1-30%)] = 1+(4*0.7) = 1+2.8 = 3.8

Ke = RFR + Beta*Risk premium

Risk-free rate (RFR) = 5%, Risk premium = 5%

Ke = 5% + 3.8 * 5% = 0.05+(3.8*0.05) = 0.05+0.19 = 0.24

Ke = 24%

Cost of Debt (Kd) = Risk free rate + Credit spread = 5% + 2% = 7%

WACC = we*Ke + wd*Kd*(1-t)

we = 20%, wd = 80%, t = 30%

WACC = 0.2*0.24+0.8*0.07*(1-0.3) = 0.048+0.0392 = 0.0872

WACC = 8.72%