Question

Canada Telecom, 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. Canada Telecom 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 Canada Telecom and XYZ have a tax rate of 35%, and a debt beta of 0.

1. Is Canada Telecom’s 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 Canada Telecom’s new project. Estimate the new project’s equity beta.
3. What is the new project’s cost of capital?

Answer 1

A. No, the WACC of Canada telecom is not the right discount rate for the new project as the WACC of Canada Telecom is the cost of capital of the telecom business and is dependent on several factors related to the telecom business like leverage, interest rates for that industry etc. The multimedia division is a different business with a different leverage profile and hence we cannot use the WACC of Canada telecom for the new multimedia business

B. The equity beta of XYZ cannot be used as a proxy even though it is in the same sector as the new multimedia business because of the difference in debt profile (35% debt financed vs. D/E of 0.6 for multimedia business)

C. First we will unlever the beta of XYZ to get unlevered beta and then re-lever it to get the beta of new multimedia division

=1.05/ ((1+(1-35%)*(35/65))) =0.78

Levering the beta for the target D/E of 0.6

Levered beta for new divition = 0.78*(1+(1-35%)*0.6) = 1.08

D. WACC = rd*(1-T)*D/(D+E) + Re*E/(D+E)

re = rf + beta*Rmrp

where

rd is cost of debt

re is cost of equity

rf is risk free rate

Rmrp is market risk premium

So re= 3% + 1.08*5% = 8.4%

rd = 6.5%

E/(D+E)= 1/(1+D/E) = 1/1.6 = 0.63

D/(D+E) = 1- E/(D+E) = 1-0.63 =0.37

So WACC = 6.5%*(1-35%)*0.37+8.4%*0.63 = 6.85% Answer