Your sister is considering buying an established and thriving cycle shop in Richmond Hill. She has asked you to help determine the appropriate price. To value the firm a discount rate will be needed. The following information has been provided.

After some contemplation, it is determined that the optimal or target debt-to-equity ratio for the company is 0.20. (We will learn how to determine optimal or target capital structure in the next series of lectures)

The tax rate is 30%.

The $8,000 bank loan was issued 4 years ago and at that time was charged 8% interest. The loan is due to mature in 5 years. If the loan were to be renewed today at the target capital structure, it would be AA rated debt. At present debt of this quality for this type of issuer earns a 250 basis point spread over government long-term bonds and 450 basis points over the 90-day T-bill rate.

Assume the beta for this firm is 0.9.

Questions:

1. Define risk premium. For which types of securities do we estimate a risk premium?
2. Do you think the risk free rate should be the 90-day T-bill rate or something else? Justify.
3. Why would you not use the 8% as the cost of debt for Cyclemania? Generally speaking, how do we measure the risk premium for debt?
4. How do we measure the risk premium for equity?

What is beta what does it measure?

What is a reasonable beta for equity? Is this business more or less sensitive to changes in market-wide factors? How would you go about answering this question?

5. Your sister would like you to explain the logic of your calculation of the equity risk premium for this firm. She thinks she should be compensated for total risk, not just some of the risk.
6. Your sister states: I will be sinking all of my wealth in the business. Do you still think it is appropriate to calculate the required rate of return on equity this way?
7. Should we use actual capital structure or target capital structure for this valuation?
8. Calculate the appropriate cost of capital for this business using the above information, ignoring the concern expressed by your sister.
9. How and where do we use the cost of capital in financial analysis?