Cost of capital and capital structure Tea&Juices, a foreign producer of soft dri
ID: 2757291 • Letter: C
Question
Cost of capital and capital structure
Tea&Juices, a foreign producer of soft drinks, is considering expanding its activities to Canada. To evaluate the profitability of the business, the management has decided to use as benchmarks two other foreign producers of soft drinks who have already entered the Canadian market:
• Fruit Juices has 2.9 million shares outstanding, trading on the TSX Venture exchange at $11.45 per share. The company pays no dividends and has issued bonds, whose nominal value is $14 million, at an average yield of 8.6%. The current average yield for similar bonds is 8.6%. Its equity beta is estimated at 1.9.
• Soft Drinks Canada has an equity beta of 2.4, an average bond yield of 9.7%, and uses an equal amount of debt and equity in its capital structure. The current average yield for similar bonds is 9.3%. To start operating, Tea&Juices will open a Canadian subsidiary firm funded with a $25 million equity investment from the parent firm, coupled with a $10 million bond offering paying a 5.9% coupon rate. The Canadian market risk premium is 5.2% and the appropriate risk free rate is 1.5%. Assume there are no distress or transaction costs, and that all companies operate in a tax-free regime.
1. What would be the cost of capital for Tea&Juices’ expansion plan, using Fruit Juices as a benchmark?
2. What would be the cost of capital for Tea&Juices’ expansion plan, using Soft Drinks Canada as a benchmark?
3. What does this intuitively suggest about Fruit Juices and Soft Drinks Canada?
4. What kinds of factors might contribute to the difference observed in part (3)?
Now assume that, everything else equal, Fruit Juices and Soft Drinks Canada pay an average corporate tax rate of 25%. Tea&Juices expects to pay a similar tax rate.
5. What would be the cost of capital for Tea&Juices’ expansion plan, using Fruit Juices as a benchmark?
6. What would be the cost of capital for Tea&Juices’ expansion plan, using Soft Drinks Canada as a benchmark?
Explanation / Answer
CALCUALTION OF COST OF EQUITY (Ke) FOR ALL COMAPANIES (Ke= Rf+B(Riisk Premium); Rf = Risk free rate; B = Beta;
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Tea & Juice Fruit Juice Soft Drinks Canada
Risk free rare 1.5 1.5 1.5
CALCULATON OFCOST OF CAPITAL OF TEA & JUICE USING FRUIT JUICE AS BENCH MARK (AMOUNT IN MILLION DOLLORS)
TOTAL 35 COST OF CAPITAL 9.814 or 9.81%
3. Soft drinks,Canada is having more beta ie. 2.4 than that of Fruit Juiece ie. 1.9, hece cost of equity of Tea & Juice is more when we use Soft drink Canada using as bench mark as its beta is more, consequently cost of capital is also more and Cost of equity of Tea & Juice is is less when we use Fruit juice beta as the base and consequenlty its overall cost of capital is also less.
4. Factors for difference will be (1) difference in beta (2) component of debt capital etc.
5. CALCULATION OF COST OF CAPITAL OF TEA & JUICE (AFTER TAKING INTO ACCOUNT TAX ADJUSTMENT) USING FUIT JUICE AS BENCH MARK (AMOUNT IN MILLION DOLLORS)
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SOURCE AMOUNT PROPORTION COST WACC