Question

Blantyre Co ltd is a toy manufacturer whose equity:debt ratio is 5:2. The corporate debt, which is assumed to be risk-free, has a gross redemption yield of 11%. The beta value of the company's equity is 1.1. The average return on the stock market is 16%. The corporation tax rate is 30%.

The company is considering a confectionery manufacturing project. The Blue Line ltd is a confectionery manufacturing company. It has an equity beta of 1.59 and an equity:debt ratio of 2:1. Blantyre Co ltd maintains its existing capital structure after the implementation of the new project.

Required: What would be a suitable risk adjusted cost of equity to apply to the project?

Answer 1

Beta of Blantyre = 1.1

Equity:Debt of Blantyre = 5:2

Tax rate (T) = 30%  

Debt yield of Blantyre = 11%

Market Return = 16%

Beta of Blue Line = 1.59

Equity:Debt of Blue Line = 2:1

Beta of Asset = Beta of Blue Line * [1 / (1 + ((1 - Tax rate) (Debt /Equity of Blue Line )))]

Beta of Asset = 1.59 * [ 1 / (1 + ((1 - 30%) * (1/2)))]

Beta of Asset = 1.1778

Beta of Project = Beta of Asset * [1 + ((1 - Tax rate) (Debt /Equity of Blantyre))]

Beta of Project = 1.1778 * [1 + ((1 - 30%) * (2 / 5))]

Beta of Project = 1.5075

Cost of Equity = Risk free rate + Beta of Project * (Market Return - Risk free rate)

Corporate debt of Blantyre is assumed to be risk-free has yield = 11%

Cost of Equity = 11% + 1.5075 * (16% - 11%)

Cost of Equity = 18.54%

Risk Adjusted Cost of Equity of the project = 18.54%