B7. (Cost of capital estimation) Managers of the Stan Lee Martin Corporation are considering
a capital budgeting project that is unrelated to their current investments. The proposed
project will be 40% debt financed at rd = 11.25%. They have identified three firms
that they believe are basically comparable to the capital budgeting project under consideration,
and they have collected the information about those comparable firms as shown
below. Assume the following hold for all firms: (1) rM = 15%, (2) rf = 7%, (3) T = 0.35,
(4) T * = 0.2, and (5) the total debt is the number of bonds indicated, each with a par
value of $1,000 and 10 years to maturity. What cost of capital would you recommend the
managers of Stan Lee Martin Corporation use to evaluate the proposed capital budgeting
project?
STOCK STOCK BOND
FIRM BETA PRICE # SHARES PRICE COUPON # BONDS
A 1.10 $25 1 million $1,100 12% 10,700
B 1.20 $30 2 million $900 10% 67,000
C 1.15 $22 5 million $850 8% 32,350
