Your firm is planning to invest in an automated packaging plant. Harburtin Industries is an? all-equity firm that specializes in this business. Suppose? Harburtin's equity beta is 0.83?, the? risk-free rate is 5%?, and the market risk premium is 6%.
a. If your? firm's project is? all-equity financed, estimate its cost of capital. After computing the? project's cost of capital you decided to look for other comparables to reduce estimation error in your cost of capital estimate. You find a second? firm, Thurbinar? Design, which is also engaged in a similar line of business. Thurbinar has a stock price of $18 per? share, with 15 million shares outstanding. It also has $110 million in outstanding? debt, with a yield on the debt of 4.4%. ?Thurbinar's equity beta is 1.00.
b. Assume? Thurbinar's debt has a beta of zero. Estimate? Thurbinar's unlevered beta. Use the unlevered beta and the CAPM to estimate? Thurbinar's unlevered cost of capital.
c. Estimate? Thurbinar's equity cost of capital using the CAPM. Then assume its debt cost of capital equals its yield and using these? results, estimate? Thurbinar's unlevered cost of capital.
d. Explain the difference between your estimate in part ?(b?) and part ?(c?).
e. You decide to average your results in part ?(b?) and part ?(c?), and then average this result with your estimate from part ?(a?). What is your estimate for the cost of capital of your? firm's project?
a. If your? firm's project is? all-equity financed, estimate its cost of capital.
The project’s cost of capital is ?? %. (Round to two decimal places.)
b. Assume? Thurbinar's debt has a beta of zero. Estimate? Thurbinar's unlevered beta. Use the unlevered beta and the CAPM to estimate? Thurbinar's unlevered cost of capital.
Thurbinar's unlevered beta is ??.
Thurbinar's unlevered cost of capital is ?? %.
c. Estimate? Thurbinar's equity cost of capital using the CAPM. Then assume its debt cost of capital equals its yield and using these? results, estimate? Thurbinar's unlevered cost of capital.
Thurbinar's equity cost of capital is ??%
Thurbinar's unlevered cost of capital is ??%
d. Explain the difference between your estimate in part ?(b?) and part ?(c?).
A. The answers are actually the same; any difference is just due to rounding errors.
B. The answers are differ because we are using approximations rather than formulas that hold exactly.
C. In the first case, we assumed the debt had a beta of zero so we assumed the cost of debt was the riskless rate, while in the second case we assumed the cost of debt was the yield to debt.
D. We should have gotten the same answer, the problem is the numbers in the problem are not consistent.
e. You decide to average your results in part ?(b?) and part ?(c?), and then average this result with your estimate from part ?(a?). What is your estimate for the cost of capital of your? firm's project?
The average unlevered cost of capital from part ?(b?) and part ?(c?) is ? %.
The average unlevered cost of capital from part ?(b?) and part ?(c?) with part ?(a?) is ?%