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%. 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. a. If your firm’s project is all equity financed, estimate its cost of capital. 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 (a) ,part (b) and part (c), and then average this result. What is your estimate for the cost of capital of your firm’s project?

Answer 1

a. If your firm’s project is all equity financed, estimate its cost of capital

Using Harburtin's equity beta,0.85

Cost of capital(as per CAPM)=RFR+(beta*Mkt. risk premium)

ie.4%+(0.85*5%)=

8.25%

b.Thurbinar’s unlevered beta=Levered Beta/(1+(Debt/equity))

ie.1/(1+((100/300))=

0.75

Thurbinar’s unlevered cost of capital=RFR+(Unlev. Beta*Market risk premium)

ie. 4%+(0.75*5%)=

7.75%

c. Thurbinar's equity cost capital

RFR+(beta*Mkt. risk premium)

ie. 4%+(1*5%)=

9%

Thurbinar’s unlevered cost of capital=

(Wt.d*kd)+(Wt.e*ke)

((100/400)*4.5%)+((300/400)*9%)=

7.875%

d. To explain the difference between estimates in part (b) and part (c)

In part b---Assumed Thurbinar’s debt has a beta of zero.

In part c--- assumed its debt cost of capital equals its yield,ie. 4.5%

e.Estimate for the cost of capital of your firm’s project is

the average results in part (a) ,part (b) and part (c)

Averaging the 3 nos.

ie. (8.25%+7.75%+7.875%)/3=

7.96%

(ANSWER)