Question

A telephone company, is contemplating investing in a project in multimedia applications. The company is currently 30% debt financed. The company’s analysts have estimated the project’s cash flows but need to determine the project cost of capital. The company's analysts assess that their new multimedia division has a target debt-equity ratio of 0.6, and a cost of debt of 6.5%. In addition, the risk-free rate is 3%, and market risk premium is 5%.

XYZ Co. is a pure play in the multimedia business and is 35% debt financed. Its current equity beta is 1.05. Assume that both the telephone company and XYZ have a tax rate of 35%, and a debt beta of 0.

1. Is the telephone company WACC the right discount rate for its new project? Why or why not?
2. Explain why you cannot use XYZ’s equity beta (1.05) as a proxy for the equity beta of the telephone company's new project. Estimate the new project’s equity beta.
3. What is the new project’s cost of capital?

Answer 1

The debt-equity ratio of 0.6 translates to a debt percentage of 1/(1/0.6+1) = 0.375 or 37.5%. The debt percentage of the multimedia business is significantly different than the debt percentage of the telephone company. Also, the businesses and hence the risks are very different for both the scenarios. Therefore, the telephone company WACC wouldn't be the right discount rate for the new project.

Since the debt percentages are different for both the firms, WACCs for both the firms will be different. Hence, we can't use XYZ's equity beta. Also, beta represents the risk and therefore the variability of the stock price of the firm. Hence, we can't use only XYZ's data because it will have many idiosyncratic risks also associated with it. But, it might be advisable to calculate the unlevered beta for the industry and from that calculate the levered beta for the specific firm.

Unlevered beta of XYZ: Beta equity*equity percentage = Beta unlevered (as Debt beta is 0). Hence, 1.05*0.65 = 0.6825. This will be the unlevered or asset beta. By using the same formula as above we calculate the equity beta of the project. Equity beta = 0.6825/(1-0.375) = 1.092.

The cost of capital will be calculated by first calculating the equity cost of capital. We use CAPM for this. re = 3 + 1.092*5 = 8.46%. So, now the cost of capital will be = 8.46*0.625 + 0.375*6.5*0.65 = 6.872%.