7 You are given the following information about Electronics plc. It has a payout ratio of 0.6, a return on equity of 20 per cent, an equity beta of 1.33 and is expected to pay a dividend next year of £2.00. There are 1 million shares outstanding and it is fairly valued. It also has nominal debt of £20 million issued at 10 per cent and maturing in 5 years. Yields on similar debt have since dropped to 8 per cent. The risk free rate is 6 per cent and the expected market return is 13.5 per cent.

(a) Find Electronics’ cost of capital and cost of equity.

(b) The company decides to retire half its debt at current prices. Find the company’s cost of capital and equity and explain your results.

(c) The company decides to diversify into a completely different business area and decides to look at Betas of firms currently trading in the new business area. The information is given below.

What discount rate should the company use for the new business?

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Company Beta Debt/Equity Market capitalisation ABC C 1.2 582 1.5 1.8 1:2 1:1 20 million 30 million No debt 50 million