Question: What is the project’s cost of equity? What is the appropriate discount factor to use for evaluating the refrigerator project?
The following assumptions are used to determine the cost of capital. Historically, the company tried to maintain a debt to equity ratio equal to 0.40. This ratio was used because lowering the debt implies giving up the debt tax shield and increasing it makes debt service a burden on the firm’s cash flow. In addition, increasing the debt level may cause a reduced rating of the company’s bonds. The marginal tax rate is 40%. All the numbers are expressed in today’s dollars. The forecasted average inflation per year is 3.5%.
Cost of debt:
The company’s bond rating is roughly at the high end of the A range. Surveying the debt market yielded the following information about the cost of debt for different rating levels:
|
Bond rating
|
AA
|
A
|
BBB
|
|
Interest cost range
|
5.5% ~ 6.5%
|
6.25% ~ 7.5%
|
7.5% ~ 9%
|
The company’s current bonds have a rating of A.
Cost of equity:
The current 10-year Treasury notes have a yield to maturity of 6% and the forecast for the S&P 500 market premium is 6.5%. The company’s overall β is 1.3.
β analysis:
|
Company
|
Tesca Works
|
Electrics Plus
|
General
Generators
|
Universal
Power
|
Generators
Inc.
|
International
Generators
|
|
Over all b
|
1.3
|
1.4
|
1.3
|
1.6
|
1.2
|
1.35
|
|
Debt to equity
|
0.4
|
0.3
|
0.5
|
0.45
|
0.35
|
0.25
|
|
Percentage of income from generators
|
50
|
45
|
90
|
95
|
85
|
85
|