American Chemical Corporation
Cost of Capital : Collinsville Investment
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D
Tc = corporate tax rate
D/V and E/V Ratio:
Since the target debt ratio of Dixon is given to be about 35%, we assume the target D/V ratio for Colinsville investment to be the same. Hence the E/V ratio = 1 ' D/V = 65%. Given the fact that Dixon and Collinsville are both specialty chemicals producing operations, the target leverage ratio of 35% for Dixon is reasonably assumed to apply to Collinsville.
Cost of Debt:
Cost of debt for Collinsville is estimated based on the long-term BBB corporate bonds at 11.25%, which is also the actual interest rate that Dixon would be paying to its creditors for financing Collinsville.
Cost of Equity:
Re = Rf + (β * Market Premium)
Cost of equity for Collinsville is estimated with the risk free rate based on long-term Treasury bonds at 9.5% since Dixon estimates the plant’s physical life to be 10 years. A historical estimate of 7.25% is used for market risk premium (the average of the historical market risk premium range of 7.0 to 7.5%).
Even though Dixon plans to finance the Collinsville investment with 100% debt, this is an internal financial decision, whereas cost of capital would be estimated based on market or optimal leverage ratios. Therefore, market value-based information on the most comparable sodium chlorate producers (i.e. Brunswick Chemical and Southern Chemicals who specialize in producing sodium chlorate) are obtained to estimate the appropriate unlevered beta for Collinsville at 1.09. As a result, Collinsville’s estimated relevered beta is 1.39.
Re = 9.5% + (1.39 * 7.25%) = 19.57%
From the perspective of Dixon Corporation, the cost of capital evaluation would start out in...