Question

Your firm is planning to invest in a new electrostatic power generation system. Electrostat Inc is a firm that specializes in business. Electrostat has a stock price of $25 per share with 16 million shares outstanding. Electrostat's equity beta is 1.18. It also has $220 million in debt outstanding with a debt beta of .08. If the risk-free rate is 3%, and the market risk premium is 6%, then your estimate of your cost of capital for electrostatic power generators is closest to:

a. 7.50%

b. 7.75%

c. 9.50%

d. 10.10%

Answer 1

Step-1, Calculation of the Overall Beta

Market Value of Equity = $40,00,00,000 [160,00,000 Shares x $25 per share]

Market Value of Debt = $22,00,00,000

Total Market Value = $62,00,00,000

Therefore, Beta = [Equity Beta x Weight of Equity] + [Debt Beta x Weight of Debt]

= [1.18 x ($40,00,00,000 / $62,00,00,000)] + [0.08 x ($22,00,00,000 / $62,00,00,000)]

= 0.761290 + 0.028387

= 0.789677

Step-2, Cost of capital

As per CAPM Approach, Cost of capital = Risk-free Rate x (Beta x Market Risk Premium)

= 3% + (0.789677 x 6%)

= 3% + 4.75%

= 7.75%

“Therefore, the cost of capital for electrostatic power generators is closest to (b). 7.75%”