Question

1. Lister Inc. is a small, publicly traded data processing company that has $200 million in debt outstanding, in both book value and market value terms. The book value of equity in the company is $400 million and there are 40 million shares outstanding, trading at $20/share. The current levered beta for the company is 1.15 and the company’s pre-tax cost of borrowing is 5%. The current risk-free rate in US $ is 3%, the equity risk premium is 5% and the marginal tax rate is 40%.

1. Estimate the current cost of capital for the company.

2. Now assume that the company plans to triple its debt to capital ratio (through a recapitalization), which will raise the pre-tax cost of debt to 8%. If the expected pre-tax operating income of the firm is $36 million, estimate the new cost of capital.

Answer 1

Step 1. Cost of equity

Expected rate of return(Ri) = risk-free rate of return(Rf) + leveraged beta(Bi)(equity risk premium(Rm) - risk-free rate of return(Rf))

Given :

Risk-free rate of return = 3%

Leveraged beta = 1.15

Equity risk premium = 5%

With the given information :-

Ri = 3 + 1.15(5-3)

Ri = 5.3%

Step 2. Cost of Debt

Kdat = kdbt (1 - tax)

Kdbt = 5%

Tax rate = 40%

Hence,

Kdat = 5%(1-40%)

Kdat = 3%

1. Answer : Cost of Capital

Cost of capital =  wd × rd × (1 - t) + we × re

Wd = weightage of debt = 20%

We = Weightage of equity = 80%

T = Tax rate = 40%

Rd = Cost of debt = 3%

Re = Cost of equity = 5.3%

Hence,

Cost of capital =  20 × 3 × (1 - 40) + 80 × 5.3

Cost of capital = 4.60%