You work in the CFOs office of Saras Holdings a corporation

You work in the CFO’s office of Sara’s Holdings, a corporation that operates in several different lines of business. You are assigned the task of estimating the cost of capital for the retail hardware division in order to evaluate additional investment in that business unit. To compute the division’s cost of capital, you gather the following information:

a. Your company has 2 million shares of common stock outstanding;

b. its recently traded share price was $18;

c. your stock’s beta was recently estimated to be 2.1;

d. your company has 5,000 bonds outstanding valued at $10,000 each with a current yield to maturity of 6%;

e. your effective corporate tax rate is 25%;

f. 25% of your company’s assets are in the retail hardware business.

g. A company that is only in the retail hardware business has:

(i) a stock beta of 2.75;

(ii) 8,500,000 shares outstanding with a recent trade price of $5.25 per share;

(iii) $75,000,000 of long-term debt with a current yield to maturity of 6.1%;

(iv) an effective corporate tax rate of 30%.

h. Currently 10 year Treasury bonds have a yield to maturity of 4.5% and the market risk premium is estimated to be around 4%.

Given the above information, what is your best estimate of the retail hardware division’s cost of capital?

Solution

Given the company has multiple divisions, using Beta and capital structure of the firm may not correctly state the risk associated with the retail harware division of the firm.

In order to correctly assess the risk associated with this division, we should use the capital and cost structure of the pure play firm, data for which is provided in question,

Cost of Equity for firm can be calculated using CAPM Equation,

Cost of Equity = Risk free rate + Beta * Market risk premium

Cost of Equity = 4.5% + (2.75 * 4%) = 15.50%

Post tax Cost of Debt = 6.1% * (1 - 30%) = 4.27%

Now, we need to calculate weights of debt and equity

Market value of equity = 5.25 * 8,500,000 = 44,625,000

Value of debt = $75,000,000 (Assuming market value is same as book value)

Total Value of Capital = 44625000 + 75000000 = $119,625,000

Weight of Equity = 44,624,000/119,625,000 = 37.30%

Weight of Debt = 75,000,000/119,625,000 = 62.70%

WACC = (37.30% * 15.5%) + (62.70% * 4.27%) = 5.78% + 2.68% = 8.46% ---> This should be used as cost of capital for retail hardware.