Exercise 2 (Exam Spring 2020)

EntertainYou Inc. is an American company that operates in two businesses; Entertainment and Cable TV. The company gets approximately 30% of its revenues from the latter. In this industry, the average beta value is 1,11 and the average debt to equity ratio is 60,17%. The average beta value in the entertainment business is 1,33 with an average debt to equity ratio of 20,07%.

EntertainYou Inc. has 500 000 shares outstanding, trading at 22,10 dollars. It has 4 513 000 dollars in debt (market value). The US treasury bond rate is 2%. EntertainYou Inc. has an operating income of 540 000 and 80 000 in interest expenses. Use a tax rate of 34% in all cases.

At the moment, the S&P 500 is at 3 400, paying 5% in dividends. The expected long-term growth in dividends is expected to be 1,8%.

1. What is the firms D/E-ratio?
2. Estimate the implied equity risk premium in the market.
3. Estimate the unlevered betas in the entertainment industry and the Cable TV industry.
4. Estimate EntertainYou Inc.s bottom-up beta.
5. Estimate the firms cost of equity.

We have the following relationships between the interest coverage ratio, the bond rating and default spread:

Spread is 15,12 % 11,34 % 8,64 % 8,20 % 5,15 % Synthetic rating If interest coverage ratio is More than Up to -100000 0,199999 0,2 0,649999 0,65 0,799999 0,8 1,249999 1,25 1,499999 1,5 1,749999 1,75 1,999999 2,2499999 2,25 2,49999 2,5 2,999999 3 4,249999 4,25 5,499999 5,5 6,499999 6,5 8,499999 8,50 100000 Rating is D2/D C2/C Ca2/CC Caa/CCC B3/B- B2/B B1/B+ Ba2/BB Ba1/BB+ Baa2/BBB A3/A- A2/A A1/A+ Aa2/AA Aaa/AAA 4,21 % 3,51 % 2,40 % N 2,00 % 1,56 % 1,22 % 1,08 % 0,98 % 0,78 % 0,63 % f) Estimate Entertain You Inc.'s cost of debt. g) What is the firm's cost of capital? Spread is 15,12 % 11,34 % 8,64 % 8,20 % 5,15 % Synthetic rating If interest coverage ratio is More than Up to -100000 0,199999 0,2 0,649999 0,65 0,799999 0,8 1,249999 1,25 1,499999 1,5 1,749999 1,75 1,999999 2,2499999 2,25 2,49999 2,5 2,999999 3 4,249999 4,25 5,499999 5,5 6,499999 6,5 8,499999 8,50 100000 Rating is D2/D C2/C Ca2/CC Caa/CCC B3/B- B2/B B1/B+ Ba2/BB Ba1/BB+ Baa2/BBB A3/A- A2/A A1/A+ Aa2/AA Aaa/AAA 4,21 % 3,51 % 2,40 % N 2,00 % 1,56 % 1,22 % 1,08 % 0,98 % 0,78 % 0,63 % f) Estimate Entertain You Inc.'s cost of debt. g) What is the firm's cost of capital