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 0.81, the? risk-free rate is 5%?, 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 $16 per? share, with 16 million shares outstanding. It also has $101 million in outstanding? debt, with a yield on the debt of 4.2%. ?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?
THE QUESTIONS:
A. If your? firm's project is? all-equity financed, estimate its cost of capital. The? project's cost of capital is _____%. ? (Round to two decimal? places.)
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.
?Thurbinar's unlevered beta is ____ ? (Round to two decimal? places.)
?Thurbinar's unlevered cost of capital is ____?%. ?(Round to two decimal? places.)
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.
?Thurbinar's equity cost of capital is ______?%. ?(Round to two decimal? places.)
?Thurbinar's unlevered cost of capital is ______%. ? (Round to two decimal? places.)
D. Explain the difference between your estimate in part ?(b?) and part (c?). ? (Select the best choice? below.)
A. In the first? case, we assumed the debt had a beta of zero so we assumed the cost of debt was the riskless? rate, while in the second case we assumed the cost of debt was the yield on debt.
B. The answers are actually the? same; any difference is just due to rounding errors.
C. We should have gotten the same? answer, the problem is the numbers in the problem are not consistent.
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?
The average unlevered cost of capital from part ?(b?) and part ?(c?) is ____?%. ? (Round to two decimal? places.)
The average unlevered cost of capital from part ?(b?) and part ?(c?) with part ?(a?) is _____?%. ? (Round to two decimal? places.)
D. The answers differ because we are using approximations rather than formulas that hold exactly.