The cost of capital for a firm can differ from the cost of

Reference no: EM13347500

The cost of capital for a firm can differ from the cost of capital for each of its businesses. When a firm has multiple businesses, it is important to use the cost of capital appropriate to the particular project under consideration, rather than the firm's overall cost of capital, when evaluating a proposed project. Renowned Cola, Inc.'s 2005 annual report explains that Renowned Cola's investments are expected to generate cash returns that exceed its "long-term cost of capital," which Renowned Cola estimated to be approximately 10% at year-end 2005. Renowned Cola has three main lines of business, soft drinks, notably Dr. Cola; snack foods, such as Fritos; and restaurants. Restaurant investments include NPC, which has a beta of 0.80 and a debt-to-firm value ratio is 0.31. Renowned Cola did not report costs of capital separately for these three businesses. Below, we have available year-end data for 2005 provided by Renowned Cola. Renowned Cola's Items Values (M = millions) Cash and marketable securities $1,498M (market value assumed) Short-term debt $706M Long-term debt $8,509M ($8,747M market value) Common shares outstanding 788M Year-end share price $55.875 Income tax rate 34% Renowned Cola's beta 1.0 Long-term borrowing rate 6.75% Short-term riskless rate 5.13% Intermediate-term riskless rate 5.50% Long-term riskless rate 6.00% Short-term market risk premium 8.40% Intermediate-term market risk premium 7.40% Long-term market risk premium 7.00% Given the above information, answer the below questions.

(1) Determine the market value of Renowned Cola's debt at year-end 2005. What is the book value of debt? Why do generally use market or book values for debt? describe.

(2) To the nearest million, determine the market value of Renowned Cola's stockholders' equity at year-end 2005.

(3) Renowned Cola subtracts the value of its short-term debt from its total debt when evaluating its "net debt ratio." Renowned Cola believes that the market values for its traded debt are not accurate because the bonds trade infrequently. Given this belief and their treatment of short-term debt, evaluate Renowned Cola's net debt ratio using book values for debt and market value for equity.

(4) Evaluate Leverage keeping the short-term debt as part of total debt. Using the CAPM compute re for short-term, medium-term, and long-term investments. Determine WACC for short-term, medium-term, and long-term investments. Consider you were considering a long-term capital investment project, which WACC would you use and why? You can consider that the asset's risk profile for the project mirrors Renowned Cola's overall risk profile.

(5) Should Renowned Cola use its overall cost of capital to determine its restaurant capital investments? Under what circumstances would it be correct to do so?

Reference no: EM13347500

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