Your firm is planning to invest in an automated packaging plant. Harburtin Indus

Question

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 0.86, the risk-free rate is 3%, and the market risk premium is 5% 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 $25 per share, with 14 million shares outstanding. It also has $102 million in outstanding debt, with a yield on the debt of 4.1%. 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?

Explanation / Answer

a Cost of capital using the CAPM model - Rf +Beta*Market premium 0.03+(0.86*0.05) 7.30% b The total value of Thurbinar's is 14(25)+102 = 350+102 = $ 452 million The assets beta is the weighted average of stock and debt beta = (102/452)(0) + (350/452)(1) = 0.774336 Now we would use CAPM model to calculate the rate of return for unlevered equity - 3 + 5*(0.774336) - 6.87168% c Equity Cost of capital - 3 + 5(1) = 8%. Therefore, the unlevered cost of capital would be (102/452)(4.1) + (350/452)(8) = 7.1199% d In part b it is assume that the debt is not risky, due to which it provides lower beta estimate and therefore lower rate of return In part c also there is an underestimate because the debt yield is less than the risky free rate, because of the rate of return is less than the yield, these numbers could be an error based on the assumption that the debt is risky. Hence this is also considered as lower estimate e If average of the two is taken we get, 6.9958% and averaging this with the original we get 7.1479%

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