Two firms, A and B, both produce widgets. The price of widgets is $1 each. Firm A has total fixed costs of $500,000 and variable costs of 50¢ per widget. Firm B has total fixed costs of $240,000 and variable costs of 75¢ per widget. The corporate tax rate is 40%. If the economy is strong, each firm will sell 1,200,000 widgets. If the economy enters a recession, each firm will sell 1,100,000 widgets.
Cost of capital and capital structure
Tea&Juices, a foreign producer of soft drinks, is considering expanding its activities to Canada. To evaluate the profitability of the business, the management has decided to use as benchmarks two other foreign producers of soft drinks who have already entered the Canadian market:
• Fruit Juices has 2.9 million shares outstanding, trading on the TSX Venture exchange at $11.45 per share. The company pays no dividends and has issued bonds, whose nominal value is $14 million, at an average yield of 8.6%. The current average yield for similar bonds is 8.6%. Its equity beta is estimated at 1.9.
• Soft Drinks Canada has an equity beta of 2.4, an average bond yield of 9.7%, and uses an equal amount of debt and equity in its capital structure. The current average yield for similar bonds is 9.3%. To start operating, Tea&Juices will open a Canadian subsidiary firm funded with a $25 million equity investment from the parent firm, coupled with a $10 million bond offering paying a 5.9% coupon rate. The Canadian market risk premium is 5.2% and the appropriate risk free rate is 1.5%. Assume there are no distress or transaction costs, and that all companies operate in a tax-free regime.
1. What would be the cost of capital for Tea&Juices’ expansion plan, using Fruit Juices as a benchmark?
2. What would be the cost of capital for Tea&Juices’ expansion plan, using Soft Drinks Canada as a benchmark?
3. What does this intuitively suggest about Fruit Juices and Soft Drinks Canada?
4. What kinds of factors might contribute to the difference observed in part (3)?
Now assume that, everything else equal, Fruit Juices and Soft Drinks Canada pay an average corporate tax rate of 25%. Tea&Juices expects to pay a similar tax rate.
5. What would be the cost of capital for Tea&Juices’ expansion plan, using Fruit Juices as a benchmark?
6. What would be the cost of capital for Tea&Juices’ expansion plan, using Soft Drinks Canada as a benchmark?