Question

Your firm is planning to invest in a new electrostatic power generation system. Electrostat Inc is a firm that specializes in this business. Electrostat has a stock price of $25 per share with 16 million shares outstanding. Electrostat's equity beta is 1.18. It also has $220 million in debt outstanding with a debt beta of 0.08. If the risk-free rate is 3%, and the market risk premium is 6%, then your estimate of your cost of capital for electrostatic power generators is closest to:

Answer 1

Answer:

The cost of capital for electrostatic power generators is closest to 7.75%

Explanation:

In order to calculate the estimate of your cost of capital for electrostatic power generators we would have to make the following calculation:

Step-1, Calculation of the Overall Beta

Market Value of Equity = $40,00,00,000 [160,00,000 Shares x $25 per share]

Market Value of Debt = $22,00,00,000

Total Market Value = $62,00,00,000

Therefore, Beta = [Equity Beta x Weight of Equity] + [Debt Beta x Weight of Debt]

= [1.18 x ($40,00,00,000 / $62,00,00,000)] + [0.08 x ($22,00,00,000 / $62,00,00,000)]

= 0.761290 + 0.028387

= 0.789677

Step-2, Cost of capital

As per CAPM Approach, Cost of capital = Risk-free Rate x (Beta x Market Risk Premium)

= 3% + (0.789677 x 6%)

= 3% + 4.75%

= 7.75%

Therefore, the cost of capital for electrostatic power generators is closest to  7.75%

Answer 2

The estimate of the cost of capital for the electrostatic power generators is closest to 7.75%.

Here, we are to calculate the estimate of the cost of capital for the electrostatic power generators by using the information in the question.

Market Value of Equity = 16,000,000 Shares * $25 per share

Market Value of Equity = $400,000,000

Given Information

Market Value of Debt = $220,000,000

The total Market Value = Market Value of Equity + Market Value of Debt

The total Market Value = $400,000,000 + $220,000,000

The total Market Value = $620,000,000

• The formula for Beta is [[Equity Beta*Weight of Equity] + [Debt Beta*Weight of Debt]}

Beta = [1.18 x ($40,00,00,000 / $62,00,00,000)] + [0.08 x ($22,00,00,000 / $62,00,00,000)]

Beta = 0.761290 + 0.028387

Beta = 0.789677

• The formula for Cost of capital is [Risk-free Rate x (Beta x Market Risk Premium)}.\

Cost of capital = 3% + (0.789677 x 6%)

Cost of capital = 3% + 4.75%

Cost of capital = 7.75%

Therefore, the estimate of the cost of capital for the electrostatic power generators is closest to 7.75%.

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