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Cost Of Capital Essay

1594 words - 7 pages

Cost of Capital- Coffee Industry
Group No. 4

Submitted to- Group Members-
Prof. Sarath Babu Himakshi Mallik
Vitash Sharma
Rahul Rishav
Avinash M
Kopparapu Prudhvi Nadh

Cost of Capital- Coffee Industry
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The basic problem, however, is that you have only book values for the private firms. This can be corrected in one of two ways
 Assume that the private firm will move to the industry average debt ratio. The beta for the private firm will then also converge on the industry average beta. This might not happen immediately but over the long term.

private firm = unlevered (1 + (1 - tax rate) (Industry Average Debt/Equity))

• Estimate the optimal debt ratio for the private firm, based upon its operating income and cost of capital. Use this optimal debt ratio to calculate the beta. (Be consistent about then using the same debt ratio in your cash flow estimates)

private firm = unlevered (1 + (1 - tax rate) (Optimal Debt/Equity))

• Step 5: Estimate a cost of equity for the private firm, based upon this beta.
• Solution 2: Estimate an accounting beta
o Step 1: Collect accounting earnings for the private company for as long as there is a history.
o Step 2: Collect accounting earnings for the S&P 500 for the same time period.
o Step 3: Regress changes in earnings for the private company against changes in the S&P 500.
o Step 4: The slope of the regression is the accounting beta

There are two serious limitations - (a) The number of observations in the regression is small (b) Accountants smooth earnings.
ESTIMATING BETAS FOR PRIVATE FIRMS
New World Coffee New York Yankees Wordperfect Corporation
Comparable Firms Beta D/E
Starbucks: 1.74 9.53%
Au Bon Pain: 1.21 31.43%
Sbarro: 1.12 0.00%
Average 1.36 13.65% Beta D/E
Topps 0.85 0.00% Beta D/E
Adobe Systems 1.70 0.00%
Borland Intl 1.35 6.00%
Lotus 1.55 2.50%
Microsoft 1.35 0.00%
Average 1.49 2.12%
Unlevered Beta for Comparable Firms 1.25 0.85 1.47
Debt/Equity Ratio for this firm 13.65%
(Assumed move to industry average) 30.00%
(Based upon management target) 10.00%
(Target Debt Ratio)
Estimated Beta for this firm 1.36 1.00 1.56
Estimated Cost of Equity 14.98% 13.00% 16.08%
ESTIMATING THE COST OF DEBT FOR A PRIVATE FIRM
• Basic Problem: Private firms generally do not access public debt markets, and are therefore not rated. Most debt on the books is bank debt, and the interest expense on this debt might not reflect the rate at which they can borrow (especially if the bank debt is old.)
• Solution 1: Assume that the private firm can borrow at the same rate as similar firms (in terms of size) in the industry.

Cost of Debt for Private firm = Cost of Debt for similar firms in the industry

• Solution 2: Estimate an appropriate bond rating for the company, based upon financial ratios, and use the interest rate estimated bond rating.

Cost of Debt for Private firm = Interest Rate based upon estimated bond rating for private firm

Note: If the beta is calculated based upon the assumption that the firm will move to its optimal debt ratio, use the corresponding bond rating.
• Solution 3: If the debt on the books of the company is long term and...

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