Question

Part B: Estimating Cost of capital for a new line of business (

Refer to the Excel file posted on Stream ‘XXX company and Market Index’ in the Assignment 1 section:

Your company is operating in a rather risky industry with the average industry beta of 1.25. Given that the products of your company are, on average, in a more volatile (to nondiversifiable factors) section of the industry, your company’s beta has been estimated as 1.32. Recently, the management team of your company is looking into another line of more stable business to expand into. As a financial manager of the company, you were asked to find the cost of capital of this new line of business (with lower risk), which will be entirely financed by equity. As of now, your company has the Debt-to-equity ratio of 1.75.

While the beta of the new project will not be observable, you know that you can observe the beta of a comparable company in such industry as a benchmark. You have chosen XXX Company for such purpose. You then asked Mr. Frank Zappa, a young intern in your company, at the very last minute of a working day to collect the daily prices of XXX company (traded in the local stock market) and the corresponding stock market index level for the last 250 trading days or so. You told him you would need that information NOW. He handed in to you the Excel file ‘XXX company and Market Index’ in the next ten minutes, looking a bit disoriented and cannot wait to call it a day.

Can ignore the tax rate. If needed 20%

QUESTIONS

1. Estimate the Beta of XXX Company estimated from the observed data just collected.

Beta of company xxx calculated through excel is = (-0.24062)

2. The debt-to-equity ratio of XXX Company is 0.5. Estimate the cost of capital (e.g. the discount rate to be used) for the new line of business that your company is considering. The relevant risk-free rate and market return are 3% and 7% respectively.

Answer 1

Information given is as under:

1. Risk free rate (Rf) : 3%
2. Market Return (Rm) : 7%
3. Beta : -0.24062
4. Debt to equity ratio : 0.5

As new line of business will be entirely financed by equity, its cost of capital is equal to cost of equity.

hence cost of capital can be calculated as

Ce (cost of equity) using CAPM method,

Ce = Rf + Beta*( Rm - Rf )

Ce = 3% + (-0.24062)*(7% - 3%) = 2.037

Therefore the cost of capital for the new line of business that company is considering will be 2.037.

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