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 the tax rate is 40%, Harburtin’s equity beta is 0.95, the risk-free rate is 3%, and the market risk premium is 5%. Use formulas that assume beta for debt is not zero for levered and unlevered cost of capital. Compute final answers using at least 3 decimal places 25 pts

a.     If your firm’s project is all equity financed, estimate its cost of capital. 5 pts

b.     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 $30 per share, with 15 million shares outstanding. It also has $100 million market value in outstanding debt, with a yield on the debt of 4.5%. Thurbinar’s equity beta is 1.00. Estimate Thurbinar’s unlevered beta. 5 pts

c.      What unlevered beta would you use to estimate the cost of capital for Harburtin’s project? 5 pts

d.     You wish to finance this project with 20% debt to value ratio and Harburtin can borrow at the same rate as Thurbinar. Compute the project’s cost of equity. 5 pts

e.     What is your estimate for the cost of capital of your firm’s project? 5 pts

using excel sheet to answer the question

Explanation / Answer

a. Cost of capital when it is fully equity financed = Rf + beta * Market risk premium = 3 + 0.95 *5 = 7.75%

b. levered beta (BL ) = 1, tax rate(T) = 40% = 0.4 , the debt to equity ratio of Thurbinar = 100/450 = 0.2222

So Unleverede Beta ( BU) = BL/ (1+(1-T)*D/E) accordint to hamada equation

Unlevered beta (BU) = 1/(1+(1-0.4)*0.2222) = 0.8823

c. The Unlevered beta of Harbutin is 0.95 since the firm already is all-equity with no debt

d. Now we need to calculate the leverd beta of Harutin Which is BL = BU*(1+(1-t)*D/E) , BL = 0.95*(1+0.6*20/80) = 1.0925

So now the cost of equity = 3 + 1.0925*5 = 8.4625%

e. Cost of capital = Weight of equity * Cost of equity + weight of debt * Cost of debt

Weight of equity = 80% = 0.8

Cost of equity = 8.4625%

Weight of debt = 0.2

After tax cost of debt = 4.5*(1-0.4) =2.7%

Hence Cost of capital = 0.8* 8.4625 + 0.2*2.7 = 7.31%

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