Carlson company finances its capital needs with 20% long term debt and 80% equity. Carlson’s outstanding debt carries a coupon rate of 8.5%, and currently has a yield to maturity of 6%. By comparison, the yield to maturity on short term federal government debt is currently 3.5%. The beta coefficient for Carlson equity was recently estimated to be 0.4. Historically, returns on short term treasuries have averaged 4.5% per year. The expected return on the overall market for upcoming years is 8.5%.
Carlson is considering going into the widget production business, where it has not operated before. Jensen Widget Corporate (JWC) has operations that are similar to those Carlson expects to run. Jensen uses 65% debt in its capital structure, and Jensen’s equity beta was recently estimated to be 1.80. Each firm has a tax rate of 35%.
(a) Provide and interpret an estimate of the systematic risk that Carlson equity holders would be exposed to in the widget business. Why does this estimate differ from the Jensen’s beta of 1.8?
(b) Provide and interpret an estimate of the cost of capital (expected return) for Carlson’s equity investment in the widget business.
c) Provide an estimate of the weighted average cost of capital for Carlson’s overall investment in the widget business. What is the purpose of obtaining this estimate?