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Question - Your company manufactures telecommunication equipment and communication software. The equipment division is asking the finance department for an estimate of its cost of capital. The company can borrow long term at 7 percent; its corporate tax rate is 40 percent. Its target debt ratio is 30 percent (debt to total financing ratio). Its beta coefficient is 1.05. The rate of interest on government bonds is currently 5.2 percent, and the market risk premium is 5 percent. The finance department has identified three single business companies with activities that are similar to those of the equipment division of the company. Their beta coefficients and debt-to-equity ratios are as follows:
Proxy A
Proxy B
Proxy C
Equity beta
0.70
1.00
1.02
Debt-to-equity ratio at market value
0.80
Required - How would you estimate the equipment division's weighted average cost of capital if that division's target debt-to-equity ratio is 1.20?
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