3 6. (10pts) Project cost of capital: Using a comparable firm: ABP Inc. is a pro
ID: 2806486 • Letter: 3
Question
3 6. (10pts) Project cost of capital: Using a comparable firm: ABP Inc. is a provider of lumber and milling equipment and all equity financed firm. a new project which is developing a GPS-based inventory tracking system, which division in ABP. companies' investment. You have the following information about the comparable company to the new ABP's technology investment: Currently, ABP starts will be a separate n Management views the risk of this investment as similar to that of other technology Levered Comparable company: leverage ratio 20%, average debt bond yield of 10.0%. Equity beta of comparable firm is 0.8 and Debt beta of comparable firm is O.5. Leverage ratio D/(E+D) Risk free rate of 2% and a market risk premium of 5% (Spts) Estimate the cost of capital of the new project (using WACC equation) (5pts) Estimate the cost of capital of the new project using beta information of comparable firmExplanation / Answer
Question 1). Solution :- Leverage ratio = 20 % i.e., Weight of debt in the capital structure = 0.20
Weight of equity in the capital structure = 1.00
Cost of equity = Risk free return + Beta of equity * Market risk premium.
= 2 % + 0.8 * 5 %
= 2 % + 4 %
= 6 %.
Cost of debt = 10 %
Cost of capital (WACC equation) = (Weight of equity * Cost of equity + Weight of debt * Cost of debt) / Total weight.
= (1.00 * 6 % + 0.20 * 10 %) / (1.00 + 0.20)
= (6 % + 2 %) / 1.20
= 8 % / 1.20
= 6.67 % (approx).
Conclusion :- Cost of capital of the new project (Applying WACC equation) = 6.67 % (approx).
Question 2). Solution :-
Cost of equity = Risk free return + Beta of equity * Market risk premium.
= 2 % + 0.8 * 5 %
= 2 % + 4 %
= 6 %.
Cost of debt = Risk free return + Beta of debt * Market risk premium.
= 2 % + 0.5 * 5 %
= 2 % + 2.50 %
= 4.50 %.
Cost of capital = 4.50 % * 0.20 / (1 + 0.20) + 6.00 % * 1 / (1 + 0.20)
= 4.50 % * 0.20 / 1.20 + 6.00 % * 1 / 1.20
= 4.50 % * 0.1667 + 6.00 % * 0.8333
= 0.75015 % + 4.9998 %
= 5.74995 % (Rounded off to 5.75 %)
Conclusion :- Cost of capital of new project (Applying the beta information) = 5.75 % (approx).
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.