6. (10pts) Project cost of capital: Using a comparable firm ABP Inc. is a provid

Question

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. Currently, ABP starts a new project which is developing a GPS-based inventory tracking system, which will be a separate division in ABP. Management views the risk of this investment as similar to that of other technology companies investment. You have the following information about the comparable company to the new ABP's technology investment pany: leverage ratio 20%, average debt bond yield of 10.0%. Equity Levered Comparable com beta of comparable firm is 0.8 and Debt beta of comparable firm is 0.5. Leverage ratio Risk free rate of 2% and a market risk premium of 5% D/(E+D) (5pts) 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 firm

Explanation / Answer

Cost of capital of new project using WACC:

Since the firm was all equity financed , WACC = Ke

Ke= Rf + MRP × unleveled beta

= 2+ 5×0.5= 2+ 2.5= 4.50%

Cost of capital using comparable firm information:

Kd= 10%

Ke= 2+ 5×0.8= 6%

Cost of capital = 10* 0.2+ 6*0.8= 2+4.8= 6.8%

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