MT480 Unit 7 Weighted Cost of Capital Estimate Example

7.96 Percent, With Every Input Dated: An MT480 Unit 7 Cost of Capital Estimate for a Mushroom Grower

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Purdue University Global

MT480: Corporate Finance

Unit 7 Cost of Capital Estimate

[Instructor Name]

[Date]

Brandywine Hollow Mushrooms, its securities and every figure are composite; the sources cited are real.

The Input Table

An input table leads the estimate, one row per figure with its value, its date and where it came from. The share price, $31.40, is the closing price on September 30, 2026, from the exchange. Shares outstanding, 48.6 million, come from the latest quarterly report. The notes' price, 92.19 percent of face value, is the dealer quote on the same date. The loan agreement sets its rate at the overnight benchmark rate plus 1.75 points. The risk-free rate, 4.3 percent, is the ten-year Treasury yield on September 30. Beta, 0.84, and the market risk premium, 5.5 percent, come from the Unit 5 analysis. The tax rate, 24 percent, combines the federal rate with Pennsylvania's tax, net of the federal deduction. Dating every input matters because each one changes daily, and a cost of capital is an estimate as of a moment.

Market Values and Weights

Equity is valued at market: 48.6 million shares at $31.40, about $1,526.04 million. The 5.40 percent notes have $350 million of face value and trade at 92.19 percent of par, the price that corresponds to a 6.40 percent yield in Unit 3, for a market value of about $322.66 million. The term loan, $140 million, reprices with short-term rates, so its market value is taken as its par value. Total capital is about $1,988.70 million. The weights are 76.74 percent equity, 16.22 percent notes and 7.04 percent term loan.

The Cost of Equity

Under the capital asset pricing model, shareholders expect the Treasury yield plus a risk charge scaled by beta, which for the grower comes to the 8.92 percent found in Unit 5. A dividend growth check, next year's dividend of $1.1704 divided by the $31.40 price plus 4.5 percent growth, gives about 8.23 percent. The two methods bracket a reasonable range, and the estimate uses the model-based 8.92 percent because the growth input in the dividend check is the less certain of the two, as Unit 4 showed.

The Cost of Debt

The relevant cost of debt is what the grower would pay to borrow today, not the coupon it agreed to years ago. For the notes, that is their 6.40 percent market yield; after the 24 percent tax deduction on interest, about 4.864 percent. For the term loan, today's benchmark of 4.30 percent plus the 1.75-point spread gives 6.05 percent; after tax, about 4.598 percent.

The Weighted Average

Weighting each cost by its share of market value gives 76.74 percent times 8.92 percent, plus 16.22 percent times 4.864 percent, plus 7.04 percent times 4.598 percent, about 7.958 percent. Rounded, the grower's cost of capital is 7.96 percent.

Using book values instead of market values would understate the cost of capital by more than three-quarters of a point.

Using book values, $683.7 million of equity, $350 million of notes and $140 million of loan, would give about 7.195 percent. Book values understate equity, which is the most expensive source, so they understate the cost of capital. A project accepted at 7.2 percent that earned only 7.5 percent would look profitable on book weights and destroy value on market weights.

Sensitivity to Beta

Beta is the least certain input. A beta of 0.74 would put equity at about 8.37 percent and the blended figure near 7.54 percent; a beta of 0.94 would lift them to about 9.47 and 8.38 percent. Unit 8 uses a hurdle rate of 8.5 percent, above the whole range, which leaves room for estimation error and for the extra risk of a new growing house.

What the Number Is For

The 7.96 percent figure measures what investors demand for the risk in the grower as it stands today. A new growing house that does what the existing houses do is close to that risk, so the 7.96 percent estimate is a sensible starting point for Unit 8. The rate fits only projects that resemble the business being valued. A riskier venture, such as a new product line sold to restaurants, would need a higher rate; a safer one, such as an energy retrofit with contracted savings, could justify a lower one. Applying one rate to every proposal would let risky ideas look better than they are and safe ones worse, a bias Graham and Harvey's survey found to be common in practice. The estimate is therefore an input to judgment, not a substitute for it.

Limits

The estimate assumes the grower's current mix of debt and equity will continue; Unit 9 considers changing it. In the Graham and Harvey (2001) survey, beta-based estimates were the most common way companies priced their equity, as here, but Fama and French (2004) caution that the model's predictions are imperfect. Brealey et al. (2020) suggest reporting a band of plausible values instead of one point, which the sensitivity section does.

References

Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of corporate finance (13th ed.). McGraw-Hill Education.

Fama, E. F., & French, K. R. (2004). The capital asset pricing model: Theory and evidence. Journal of Economic Perspectives, 18(3), 25-46. https://doi.org/10.1257/0895330042162430

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7