Question

Books Inc. is a publicly traded publishing company. It has a current stock price of $75 per share and an equity beta of 0.8. Books is consistently profitable and faces a marginal tax rate of 21%. It also maintains a target leverage ratio of 40%. Books’ debt is AAA-rated and can be considered essentially risk free. The risk free rate in the economy is 5% and the market premium is 4%. You may assume that the CAPM holds.

Please use the field below to provide work associated with your answers to follwoing. You may assume that all of the information above applies to all of those questions, except where the questions explicitly state otherwise.

a. What is Books' after-tax weighted average cost of capital? (Please express your answer in percentage form, rounded to the nearest tenth. For example, enter 50.2 for 50.2%.)

b. What is Books' after-tax weighted average cost of capital? (Please express your answer in percentage form, rounded to the nearest tenth. For example, enter 50.2 for 50.2%.)

c. What is the debt capacity created by the new investment project at the time it is initiated? (Please express your answer in millions of dollars, rounded to the nearest hundredth. For example, $100.569 million should be entered as $100.57.)

d. Suppose that Books also has the opportunity to create an online division that will focus on digital distribution of content. Books believes that ultimately the business risk of this new venture is comparable to the business risk of its existing operations. However, the new division will have fewer tangible assets. So, Books would manage the division at a target leverage ratio of 20% instead of 40%. What is the business risk (i.e., β O A) of Books existing operations? (Please express your answer rounded to the nearest hundredth. For example 1.569 should be entered as 1.57.)

d. What would be an appropriate opportunity cost of capital (or after-tax WACC) for Books to use to value free cash flows in its new online division? (You may assume that the cost of debt capital is the same for the online division as for the existing operations. Please express your answer as a percentage, rounded to the nearest hundredth. For example 10.569% should be entered as 10.57.)

Answer 1

a. The cost of equity can be estimated by employing the CAPM model as follows:

Risk free rate + Beta * Market Premium

5% + 0.8 * 4%

= 8.20%.

The debt of Book Inc. is rated as AAA and considered to be risk free. Hence, the cost of debt for the organization is 5%. The marginal rate of tax is given as 21%. Therefore, the after tax cost of debt is 5% * (1-0.21) = 3.95%.

The leverage ratio for the organization is given to be 40%. Therefore, the weight of debt in the capital structure of the company is 40% while the same for equity is 60%.

Hence, the after tax weighted average cost of capital for the company is computed as follows:

0.6 * 8.20% + 0.4 * 3.95% = 6.5.

b. The after tax weighted average cost of capital for Book Inc. is 6.5.