The cost of capital for a firm can differ from the cost of capital for each of its businesses. When a firm has manifold businesses, it is important to use the cost of capital suitable to the particular project under consideration, rather than the firm's overall cost of capital, when calculating a proposed project. Renowned Cola, Inc.'s 2005 annual report describes that Renowned Cola's investments are expected to produce cash returns which exceed its ‘long-term cost of capital,’ which Renowned Cola estimated to be about 10% at year-end 2005. Renowned Cola has three main lines of business, soft drinks, notably Dr. Cola; snack foods, like Fritos and restaurants. Restaurant investments include NPC, which has a beta of 0.80 and a debt-to-firm value ratio is 0.31. Renowned Cola did not report costs of capital separately for such three businesses. Below, we have available year-end data for 2005 given by Renowned Cola.
Renowned Cola’s Items Values (M = millions)
Cash and marketable securities $1,498M (market value assumed)
Short-term debt $706M
Long-term debt $8,509M ($8,747M market value)
Common shares outstanding 788M
Year-end share price $55.875
Income tax rate 34%
Renowned Cola's beta 1.0
Long-term borrowing rate 6.75% Short-term riskless rate 5.13%
Intermediate-term riskless rate 5.50%
Long-term riskless rate 6.00%
Short-term market risk premium 8.40%
Intermediate-term market risk premium 7.40%
Long-term market risk premium 7.00%
From the above information, answer the following problems:
problem 1: find out the market value of Renowned Cola's debt at year-end 2005. Determine the book value of debt? Why do usually use market or book values for debt? describe.
problem 2: To the nearest million, find out the market value of Renowned Cola's stockholders' equity at year-end 2005.
problem 3: Renowned Cola subtracts the value of its short-term debt from its total debt when computing its ‘net debt ratio’. Renowned Cola believes that the market values for its traded debt are not accurate as the bonds trade infrequently. Given this belief and their treatment of short-term debt, find out Renowned Cola's net debt ratio by using book values for debt and market value for equity.
problem 4: Compute Leverage keeping the short-term debt as a part of the total debt. By using the CAPM compute re for short-term, medium-term and long-term investments. Compute WACC for short-term, medium-term and long-term investments. Suppose that you were considering a long-term capital investment project, which WACC would you use and why? You can assume that the asset's risk profile for the project mirrors Renowned Cola's on the whole risk profile.
problem 5: Must renowned Cola use its overall cost of capital to evaluate its restaurant capital investments? Beneath what conditions would it be right to do so?