Question

In: Finance

Marcosoft Inc. is a publicly traded company that operates in the software and entertainment business, deriving...

Marcosoft Inc. is a publicly traded company that operates in the software and entertainment business, deriving 60% of its value from software and 40% from entertainment. You have collected the following information on comparable firms:

Comparable companies

Leveraged beta

D/E ratio

Software industry

1.40

0.25

Entertainment

1.25

0.5

Macrosoft has 60 million shares outstanding, trading at $10/share and $180 million in 10-year corporate bonds (with a coupon rate of 4%) outstanding, trading at par. The company also has lease commitments of $40 million a year for the next 6 years and a marginal tax rate of 40%.

  1. Estimate the current debt to equity ratio (in market value terms) for Macrosoft (make sure to capitalise the lease commitments)
  2. Estimate the levered beta for the company
  3. Estimate the current cost of equity for the company if risk free rate (Rf) is 2% and the market risk premium (Rm – Rf) is 5.8%
  4. Finally, compute the cost of capital for the company

Solutions

Expert Solution

a) since bonds are trading at par we are assuming cost of debt is equal to the coupon rate

Working Note 1) Fig in $ millions
Year cashflow Tax(40%) After tax cashflow discount factor @4% PV of cashflows
1 40 16 24 0.962 23
2 40 16 24 0.925 22
3 40 16 24 0.889 21
4 40 16 24 0.855 21
5 40 16 24 0.822 20
6 40 16 24 0.790 19
Capitalized Lease 126
Particulars
No of shares outstanding ( $ Million) 60
Rs per share ($) 10
Value of Equity ( $ Million) 600
Particulars
Debt 180
lease 126
Total debt ($ Millions) 306

Debt to equity = 306/600 =51% = 0.51

2) First we calculate the unlevered beta of the two industries by the following formula

BU = BL / [1 + ((1 - Tax Rate) x Debt/Equity)]

Software industry has D/E = 0.25 so,

Software industry = 1.4/ (1 + (0.6*0.25) )

= 1.217

Entertainment industry = 1.25 / (1+(0.6*0.5) ) = 0.962

Now marcosoft is 60% software and 40% entertainment

so unlevered beta pf Marcosoft = 0.6*1.217 +0.4*0.962 = 1.115

so levered beta of Marcosoft is calculated with the fomula BL = BU * [1 + ((1 - Tax Rate) x Debt/Equity)]

= 1.115 * (1 + 0.6*0.51) = 1.46

so levered Beta of Marcosoft is 1.46

C) Rf=2% Rm-Rf=5.8%

so cost of equity = 2+ (5.8)*1.115 = 8.47

jeff jeffy answered 1 year ago
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