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

beta=(75%*0.88)+(25%*1.13)=0.94

Cost of equity=8%+(0.94*5.5%)=13.18%

Cost of debt=yield of A rated bonds=10%

Market value of equity=twice of book value=2*$120 million=$240 million

Market value of the debt can be found using PV function in EXCEL

=PV(rate,nper,pmt,fv,type)

rate=10%

nper=10

pmt=5 million

fv=60 million

=PV(10%,10,5,60,0)=$53.86 million

Total value=$240 million+$53.86 million=$293.86 million

Weight of equity=Market avlue of equity/Total value=$240/$293.86=81.67%

Weight of debt=Market value of debt/Total Value=$53.86/293.86=18.33%

Weighted average cost of capital=(weight of equity*cost of equity)+(weight of debt*cost of debt)=(81.67%*13.18%)+(18.33%*10%)=12.60%