Please do your answers on an Excel spreadsheet, using one tab per question. The alternative is to use pen and paper and submit these as a PDF (but this is not ideal.)

4. Beta.

Nightjar Ltd is trying to estimate a cost of capital to use in assessing its entry into the market for manufacturing of kitset kitchens. The publicly traded firms in this market have an average equity beta of 1.7 and an average D/E ratio of 1.8. There is intense competition within the industry for business. Nightjar itself carries a D/E ratio of 0.9 with a cost of debt of 4.5 percent. Nightjar plans to maintain this D/E ratio on its new venture.

The risk free rate is 2.5 percent and the required return on the market is 12.5 percent. The average effective tax rate for firms in the industry is 33 percent but Nightjar Ltd faces a tax rate of 28 percent.

Required:

1. Estimate the appropriate beta and also the cost of capital for this new venture if the debt beta is assumed to be zero. ( 6 marks)
2. Now assume the debt beta for all publicly-traded firms in the whiteware market (including Nightjar Ltd in the future) is 0.2. Re-estimate the appropriate beta and cost of capital for this venture. ( 12 marks)
3. Prove that the value of the debt beta is indeed exactly 0.2 ( 2 marks)

TOTAL: 20 MARKS