1. You have been asked to review the cost of capital computation for Lemur Inc., a small retail company.
- The company currently has 80 million shares trading at $10 a share, no conventional debt and has estimated its cost of capital to be 10% (based upon a 100% equity ratio).
- However, the firm has lease commitments of $ 25 million a year for the next 5 years and $ 15 million a year for the following 3 years.
If the pre-tax cost of debt for the firm is 4% and the marginal tax rate is 40%, estimate the correct cost of capital.
(You can assume that the company’s cost of equity will remain unchanged)
2. You are trying to estimate the cost of capital to use in assessing a new investment venture in the entertainment business, for TechSmith Inc, a publicly traded electronics company. You have been provided the following information:
• The beta for TechSmith, based upon stock prices for the last 5 years, is 1.65 but the unlevered beta for entertainment companies is 1.08.
• At the moment, TechSmith has one bank loan outstanding, with a principal payment due of $100 million at the end of 10 years and interest payments of $5 million every year for the next 10 years.
- TechSmith also has lease commitments of $50 million a year, due at the end of each year for the next 6 years.
• TechSmith has 75 million shares outstanding, with a stock price of $15/share.
• TechSmith has a bond rating of Baa, with a default spread of 3.5% over the risk free rate.
- The marginal tax rate is 40% but TechSmith’s effective tax rate is 25%.
• The riskfree rate is 2.7% and the equity risk premium is 5.8%.
a. Estimate the market value of the interest bearing debt.
b. Estimate the debt value of lease commitments.
c. Estimate the cost of capital for this project, assuming that it will be funded using the same debt ratio that TechSmith uses today.