Question

The CEO of FUN Corp. believes the cost of capital used in the previous question is inaccurate. You have been assigned to estimate cost of capital for FUN Corp.

• The company has a capital structure which consists of 80% long-term debt and 20% common stock.
• The company’s credit rating is Ba1/BB+ (equivalent to spread of 2%). Beta of debt is 0.
• The company’s common stock currently sells for $35 per share with 2.5 million shares outstanding.
• The company’s marginal tax rate is 30%. Market risk premium is 5%. Risk-free rate is 5%.
• FUN Corp.’s most comparable competitor is Toy Inc. who has no debt. Toy Inc’s equity beta is 1.4.

Answer the following questions (please show reasonings or calculations):

1. What is Toy Inc’s cost of capital?
2. What is FUN Corp’s cost of capital?

Answer 1

Risk free Rate = 5%
Market Risk Premium = 5%

Toy Inc
Beta = 1.4
Debt/Equity = 0

Cost of Equity = Risk free rate + Beta * Market Risk Premium
= 5% + 1.4 * 5%
= 5% + 7%
Cost of Equity = 12%

Since there is no debt, therefore, the cost of equity = cost of capital

Fun Inc
Debt/Equity = 80/20 = 4
Tax Rate = 30%
Unlevered beta of Toy Inc = 1.4

The levered beta of Fun Inc = Unlevered Beta of Toy Inc *{1 + [(1-Tax Rate) * (Debt/Equity)]}
= 1.4 * {1 + [(1-0.3)*4]}
= 1.4 * [1+ (0.7*4)]
= 1.4 * [1+2.8]
= 1.4 * 3.8
= 5.32

Cost of Equity = Risk free rate + Beta * Market Risk Premium
= 5% + 5.32 * 5%
= 5% + 26.6%
= 31.6%

Cost of Debt = Risk-Free Rate + Spread
= 5% + 2%
= 7%

Cost of Capital = Cost of Equity * weightage of Equity + Cost of Debt * weightage of debt
= 31.6% * 0.2 + 7% * 0.8
= 6.32 + 5.6
Cost of Capital = 11.92%

Cost of Capital of Fun Inc is 11.92%