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

a]

Toy Inc. has not debt. Therefore, its cost of capital equals its cost of equity

cost of equity = risk free rate + (beta * market risk premium)

cost of equity = 5% + (1.4 * 5%) = 12%

cost of capital = 12%

b]

cost of debt = yield * (1 - tax rate)

yield = risk free rate + spread = 5% + 2% = 7%

cost of debt = 7% * (1 - 30%) = 4.9%

levered beta = unlevered beta * (1 + (1 - tax rate) * (debt / equity))

beta of FUN Corp = 1.4 * (1 + (1 - 30%) * (80% / 20%))

beta of FUN Corp = 5.32

cost of equity = risk free rate + (beta * market risk premium)

cost of equity = 5% + (5.32 * 5%) = 31.60%

cost of capital = (weight of debt * cost of debt) + (weight of equity * cost of equity)

cost of capital = (80% * 4.9%) + (20% * 31.60%)

cost of capital = 10.24%