112 Corporate Finance
- You are in the process of coming out with a public issue. So you are interested in cost of equity. This is the first public
issue. So there is no stock market history for your company. How would you estimate the cost of equity if:- There are comparable firms.
- There are no comparable firms in the country.
- Using the data given below estimate cost of capital.
Beta = 1.2, Rf = 12.15 percent, market premium = 10 percent. The company has stated that it intends to maintain a debt to
value ratio of 0.40. The yield on the company’s bonds is 13.5 percent. The company’s marginal tax rate is 35 percent. - Given the following book and market value data calculate WACC based on book value weights and market value weights.
Assume suitable CAPM parameters.
Book value Market value
Long term debt (12 percent) 600,000 650,000
Preferred stock (15 percent) 150,000 180,000
Equity 250,000 470,000- Sushill Shyam Sundar is the finance manager of a biotechnology company. His company shares characteristics of both
companies: pharmaceutical and specialized chemicals. So obtaining a pure play proxy beta is difficult. He reasoned: The
beta of a company is dependent on fundamental factors like sales growth, investment in R&D, etc. He ran a regression
program between unlevered betas of publicly traded pharmaceutical, specialty chemicals and biotechnology companies
and the determinants of beta. The following regression result was obtained:
βu = 2.348 + 0.214 Sales growth + 0.687 R&D/Sales – 0.081 ln(capital ) + 0.394 (NOPAT margin) – 0.205 (Sales/
Capital)
His company has the following characteristics:
ln^10 Cap Sales growth R&D/Sales NOPAT margin
10 25 percent 15 percent 25 percent
Estimate beta for the company.- The Electricity Regulatory Commission is in the process of estimating cost of equity for electric companies. The commission
regulates the price per unit of electricity the electric company can charge and hence the return on equity (assuming that
expenses are constant or increase in a definite fashion). The idea is to add a constant spread to the cost of equity to
calculate the allowable return on equity and work backwards to calculate price per unit. The Commission decided to use
the Gordon Model. The model requires estimation of constant dividend growth in the long run. Either the historic dividend
growth rate or a forecast might be used. The officials reasoned that the growth rate in earnings and dividends is a function
of: CPI inflation, yield on long term T-bond and growth rate in GDP. Using macroeconomic data the commission obtained
the following regression results:
Divgro = 0.9671 + 0.7028 CPI inflation
The other factors were found to be uncorrelated. If the forecast of inflation is 7 percent, what is the expected growth rate
in dividends? Do you think this method is appropriate for other types of businesses?
(^10) Natural log.