- 10 Marks
FM – L2 – Q38 – Cost of capital
Calculate cost of equity and WACC for Akomo Plastics Plc's investment in chemicals manufacturing using CAPM and given beta data.
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.
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