Question

Carlson Corporation finances its capital needs with 20% long term debt and 80% equity. Carlson’s outstanding debt carries a coupon rate of 8.5%, and as of now has a yield to maturity of 6%. By comparison, the yield to maturity on short term U.S. Treasury Bills is currently 3.5%. The beta coefficient for Carlson Corporation’s equity was recently estimated to be 0.6. Historically, returns on short term treasuries have averaged 4.5% per year. The expected return on the overall market for upcoming years is 8.5%.

Carlson is considering going into the widget production business, where it has not operated before. Carlson’s analysts have estimated in light of Carlson’s funding methods and the competitive nature of the widget business that the beta of the widget cash flows will be 1.1. Carlson’s marginal tax rate is 35%.

(a) Which of the two beta estimates described above is relevant for computing the NPV of the widget production proposal, and why?

(b) Provide and interpret an estimate of the cost of capital (expected return) for Carlson’s equity investment in the widget business.

(c) Provide an estimate of the weighted average cost of capital for Carlson’s overall investment in the widget business. What is the purpose of obtaining this estimate?

Answer #1

a) | The relevant beta is the beta of widget business. It is | |

1.1. | ||

b) | Levered equity beta for Carlson's widget business = 1.1*(1+0.65*20/80) = | 1.28 |

Carlson's equity cost of capital for widget business = 4.5%+1.28*(8.5%-4.5%) = | 9.62% | |

c) | WACC for Carlsons widget business = 6%*(1-35%)*20%+9.62%*80% = | 8.48% |

The purpose of obtaining the estimate of WACC is to | ||

use it as a discount rate to evaluate Carlson's | ||

widget business. |

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