As the CFO of Finance Rocks (FR) Inc., you are considering building a book factory. You determine that you will use a D/E ratio of 2 and the after-tax cost of debt is 5%. To get the cost of equity for the factory you plan to use information from a comparable firm, Accounting Not So Much (ANSM) Inc. The beta on ANSM’s stock is 1.2 and its D/E is 1. If the T-bond rate is 6% and Market Risk Premium is 5.5%. The tax rate for FR and ANSM is 40%. Assume both firms have no bankruptcy risk and debt beta is zero.
a. What is the cost of equity for the project?
First find βA: βA = 1.2/ [1+(1-0.4)(1)]=0.75
Find project’s βE: βE=0.75[1+(1-0.4)(2)]=1.65
Find project’s re: re=0.06+(1.65)(0.055)=0.1508=15.08%
b. What is the project’s WACC?
D/E=2? You use 2/3 debt and 1/3 equity so D/D+E=2/3 and E/D+E=1/3
WACCproject = (1/3)(0.1508) + (2/3)(0.05)=8.36%
c. How would bankrupsy risk affect the previous answers?
d. How would a debt beta greater than one affect the previous answers?