Question

Dunkin currently has a capital structure of 60 percent debt and 40 percent equity, but is considering a new product that will be produced and marketed by a separate division. The new division will have a capital structure of 80 percent debt and 20 percent equity. Dunkin has a current beta of 2.1, but is not sure what the beta for the new division will be. AMX is a firm that produces a product similar to the product under consideration by Dunkin. AMX has a beta of 1.8, a capital structure of 35 percent debt and 65 percent equity and a marginal tax rate of 40 percent. Dunkin' tax rate is 40 percent. What will be Dunkin's weighted cost of capital for this new division if the after-tax cost of debt is 8 percent, the risk-free rate is 7 percent, and the market risk premium is 9 percent?

Answer 1

a. Computation of Beta Unlevered

Beta Unlevered = Beta Levered / (1 + (1-Tax)(D/E))

Beta Unlevered = 1.80 / (1 + (1-0.40)(0.35/0.65))

Beta Unlevered = 1.36

b. Computation of Beta levered for Dunkin's New Product

Beta Levered = Beta UnLevered * (1 + (1-Tax)(D/E))

Beta Levered = 1.36 * (1 + (1-0.40)(0.80/0.20))

Beta Levered of Dunkins = 4.62

b. Dunkin's Cost of Equity

Using CAPM Equation, Cost = Risk Free Rate + Beta * Market Premium

Using CAPM Equation, Cost = 7% + 4.62 * 9%

Using CAPM Equation, Cost = 7% + 41.62%

Using CAPM Equation, Cost = 48.62%

d. Dunkins Weighted AVerage Cost of Capital

Dunkins Weighted AVerage Cost of Capita = Weight of Debt * Cost + Weight of Equity * Cost

Dunkins Weighted AVerage Cost of Capita = 0.80 * 8 + 0.20 * 48.62%

Dunkins Weighted AVerage Cost of Capita = 16.12%