IDX Tech is looking to expand its investment in advanced security systems. The project will be

QUESTION

IDX Tech is looking to expand its investment in advanced security systems. The project will be financed with equity. You are trying to assess the value of the investment, and must estimate its cost of capital. You find the following data for a publicly traded firm in the same line of business: Debt Outstanding (book value, AA-rated) $400 million Number of shares of common stock 80 million Stock price per share $15.00 Book value of equity per share $6.00 Beta of equity 1.20 What is your estimate of the projects beta? What assumptions do you need to make?
Answer: Given equity beta = 1.20 Since IDX Tech has an outstanding debt, the given equity beta is levered beta. Project of Advanced Security Systems is an all equity project and hence one cannot use the given equity beta of 1.20 for computing the cost of capital of the project and assess the value of investment in the project. Given beta needs to be unlevered and then should be used for computing the cost of capital Debt Outstanding (book value) = $400 million Number of shares of common stock = 80 million Book value of equity per share = $6.00 Total book value of all common stock = $6.00 * 80 million = $480 million Debt equity ratio = 400 / 480 = 5 / 6 Note: Since the book value of

debt is given, book value of common stock has been used. One can also use market value of common stock for computing the value of equity for the purpose of debt-equity ratio. Value of common stock as per market rate = 80 million share * $15.00 (stock price per share) = $1,200 million Unlevered beta = Levered beta / [1 + (1 tax rate) * Debt / Equity ratio] Assuming tax rate nil. Unlevered Beta = 1.20 / (1 + 5 / 6) = 0.6545 Hence, the project beta = 0.6545

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