Question

1. JP Inc. is a small company in the business of producing and selling musical CDs and cassettes and it is also involved in promoting concerts. JP`s stock has been listed on the NASDAQ for the last two years and is trading at twice the book value of equity. (The book value of equity is $120M). JP derives 75% of its total market value from its record/CD business and 25% from the concert business. While the price data on the company is insufficient to estimate a beta, the beta of comparable firm in these businesses is as follows.

Business	Average asset beta
Record/CD	0.88
Concert Business	1.13

The debt is composed of ten year bonds of 60M at maturity with annual coupon payment of 5M per year and is rated A (typical A rated bonds are yielding 10% currently in the market). The current risk free rate is 8% and market risk premium is 5.5%. Assume no corporate taxes

1. Estimate the current cost of equity?
2. Estimate the current weighted average cost of capital?

Answer 1

a) The Beta of JP Inc.is weighted average of division's beta

= 75%*0.88 + 25%*1.13 = 0.9425

So, from CAPM

Cost of equity = risk free rate + beta * market risk premium

= 8% + 0.9425*5.5% = 0.131838 or 13.18%

b) Market value of Debt = present value of bonds = 5M/0.1*(1-1/1.1^10) + 60M/1.1^10 = $ 53.85543M

Market value of equity = $120M*2 = $240M

weight of equity = 240/(240+53.85543) = 0.816728

weight of Debt = 1- 0.816728 =0.183272

So, WACC = weight of Debt* cost of debt + weight of equity * cost of equity (as there is no tax)

=0.183272*10% + 0.816728*13.18%

=0.126003 or 12.60%