EBK FOUNDATIONS OF FINANCE
10th Edition
ISBN: 9780135160473
Author: KEOWN
Publisher: PEARSON CO
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Chapter 9, Problem 21SP
a)
Summary Introduction
To determine: The divisional cost of capital for the E&P divisions.
b)
Summary Introduction
To determine: The implications of using firm wide cost of capital to evaluate new investment proposal in estimated cost of capital.
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(Divisional costs of capital and investment decisions) Saddle River Operating Company (SROC) is a Dallas-based independent oil and gas firm. In the past, the firm's managers have used a single firm-wide cost of
capital of 17 percent to evaluate new investments. However, the firm has long recognized that its exploration and production division is significantly more risky than the pipeline and transportation division. In fact, firms
comparable to SROC's E&P division have equity betas of about 1.8, whereas distribution companies typically have equity betas of only 0.8. Given the importance of getting the cost of capital estimate as close to
correct as possible, the firm's chief financial officer has asked you to prepare cost of capital estimates for each of the two divisions. The requisite information needed to accomplish your task is presented here:
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A firm’s cost of capital is often a reflection of its activities and funding needs. Consider the case of Wizard Company, and answer the following questions:
Wizard Co. currently has only a real estate division and uses only equity capital; however, it is considering creating consulting and distribution divisions. Its beta is currently 1.3. The risk-free rate is 4.4%, and the market risk premium is 6.2%.
This means that the firm’s real estate division will have a cost of capital of:
10.12%
12.46%
3.08%
8.80%
The consulting division is expected to have a beta of 2.1, because it will be riskier than the firm’s real estate division.
This means that the firm’s consulting division will have a cost of capital of:
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18.77%
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18.37%
The distribution division will have less risk than the firm’s real estate division, so its beta is expected to be 0.5.
This means that the distribution division’s cost of…
Consider the setting of Problem 18. You decided to look for other comparables to reduce estimation error in your cost of capital estimate. You find a second firm, Thurbinar Design, which is also engaged in a similar line of business. Thurbinar has a stock price of $20 per share, with 15 million shares outstanding. It also has $100 million in outstanding debt, with a yield on the debt of 4.5%. Thurbinar’s equity beta is 1.00.
(1) Assume Thurbinar’s debt has a beta of zero. Estimate Thurbinar’s unlevered beta. Use the unlevered beta and the CAPM to estimate Thurbinar’s unlevered cost of capital.
(2) Estimate Thurbinar’s equity cost of capital using the CAPM. Then assume its debt cost of capital equals its yield, and using these results, estimate Thurbinar’s unlevered cost of capital.
(3) Explain the difference between your estimates in part (1) and part (2).
(4) You decide to average your results in part (1) and part (2), and then average this result with your estimate from Problem 18.…
Chapter 9 Solutions
EBK FOUNDATIONS OF FINANCE
Ch. 9 - Define the term cost of capital.Ch. 9 - Prob. 2RQCh. 9 - Why do firms calculate their weighted average cost...Ch. 9 - Prob. 4RQCh. 9 - Prob. 5RQCh. 9 - Prob. 6RQCh. 9 - Prob. 7RQCh. 9 - Prob. 1SPCh. 9 - Prob. 2SPCh. 9 - (Cost of equity) In the spring of 2018, the Brille...
Ch. 9 - Prob. 4SPCh. 9 - Prob. 5SPCh. 9 - Prob. 6SPCh. 9 - Prob. 7SPCh. 9 - (Cost of internal equity) Pathos Co.s common stock...Ch. 9 - (Cost of equity) The common stock for the Bestsold...Ch. 9 - Prob. 10SPCh. 9 - Prob. 11SPCh. 9 - Prob. 12SPCh. 9 - a. Rework Problem 9-12 as follows: Assume an 8...Ch. 9 - (Capital structure weights) Wingate Metal...Ch. 9 - (Weighted average cost of capital) The capital...Ch. 9 - Prob. 17SPCh. 9 - Prob. 18SPCh. 9 - Prob. 19SPCh. 9 - (Divisional costs of capital and investment...Ch. 9 - Prob. 21SPCh. 9 - Prob. 2.1MCCh. 9 - If you were to evaluate divisional costs of...
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