Cost of Capital
Three Ton Mantis, an American wireless firm, wants to move into the Toronto's cellular carrier market. Being a little uncertain about the market conditions though, it has decided to compare its proposed offering with two other startups who are also vying the steal away market share from the market carriers. Toronado Cellular has 2.9 million shares trading on the TSX Venture exchange for $11.45 per share but it offers no dividends. It also has $14 million in debt outstanding at an average cost of 8.6%. Market analysts estimate its beta at 1.9. Big Comm Canada has a beta of 2.4, an average cost of debt of 9.3%, and uses an equal amount of debt and equity in its capital structure. The Canadian market risk premium is estimated to be 5.2% and the appropriate risk free rate to use is 1.5%. Assume there are no distress costs.
To move into this market Three Ton Mantis will have to open a Canadian subsidiary firm which would be funded with a $25 million capital investment in the form of equity from the parent firm, coupled with a $10 million bond offering paying a 5.9% coupon rate. Like Toronado and Big Comm, Three Ton's subsidiary would pay an average corporate tax rate of 25%.
a) With Toronado as a comparison firm, estimate the cost of capital for Three Ton Mantis' expansion plan.
b) With Big Comm as a comparison firm, estimate the cost of capital for Three Ton Mantis' expansion plan.
c) Do you find similar estimates for the cost of capital for Three Ton Mantis' expansion plan in parts (a) and (b)? What do the results in parts (a) and (b) intuitively suggest about the two comparable firms (i.e., Big Comm and Toronado)? What kinds of factors might contribute to this difference?
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