- 10 Marks
FM – L2 – Q38 – Cost of capital
Question
Akomo Plastics Plc is engaged in plastics manufacture. It is now considering a new investment that would involve diversification into chemicals manufacture, where the business risk is very different from the plastics manufacturing industry.
Research has produced the following information about three companies currently engaged in chemicals manufacturing, in the same part of the industry that Akomo Plastics Plc is planning to invest.
| Company | Equity beta | Financed by: |
|---|---|---|
| A | 2.66 | 40% equity capital, 60% debt capital |
| B | 1.56 | 75% equity capital, 25% debt capital |
| C | 1.45 | 80% equity capital, 20% debt capital |
Akomo Plastics Plc is financed by 60% equity capital and 40% debt capital, and would intend to maintain this same capital structure if the new capital investment is undertaken.
The risk-free rate of return is 5% and the return on the market portfolio is 9%. Tax is at the rate of 25%. You should assume that the debt capital of Akomo Plastics Plc and Companies A, B and C is risk-free.
Required
(a) Calculate a suitable cost of equity for the proposed investment by Akomo Plastics Plc in chemicals manufacturing.
(b) Suggest a weighted average cost of capital that should be used to carry out an investment appraisal (NPV calculation) of the proposed project.
Answer
(a) Cost of equity
The first step is to use the equity betas of the three chemical manufacturing companies (proxy companies) to estimate an asset beta for the business risk in chemicals manufacturing.
| Company | Estimated asset beta |
|---|---|
| A | 2.66 × [40 / 40 + 60(1-0.25)] = 2.66 × 0.4706 = 1.25 |
| B | 1.56 × [75 / 75 + 25(1-0.25)] = 1.56 × 0.80 = 1.25 |
| C | 1.45 × [80 / 80 + 20(1-0.25)] = 1.45 × 0.8421 = 1.22 |
It is assumed that the asset beta is a simple average of these three values:
(1.25 + 1.25 + 1.22) / 3 = 1.24.
This asset beta can be used to calculate an equity beta for Akomo Plastics Plc, for the investment in chemicals manufacturing:
1.24 = βe × [60 / (60 + 40(1-0.25))]
0.667 βe = 1.24
βe = 1.86
If an appropriate equity beta for Akomo Plastics Plc in chemicals manufacturing is 1.86, the cost of equity (using the CAPM) is:
5% + 1.86(9-5)% = 12.44%
(b) WACC
If the cost of equity is 12.44%, the pre-tax cost of debt is 5% (= risk-free rate) and tax is 25%, a suitable discount rate for evaluating the proposed investment would be:
(60% × 12.44%) + [40% × 5(1-0.25)] = 8.964%, say 9%.
- Topic: Cost of capital
- Uploader: Samuel Duah