Chapter 12, Problem 2CC

Summary Introduction

Case summary:

Company H is a privately held motor company. Person B, the owner of Company H invented the method of manufacturing battery for electric cars at a cheaper rate with a higher mileage. His company gained popularity and competed with other auto manufacturers. The previous year’s sales were $97,000,000. It has expanded its operations steadily whenever it had excess profits.

However, the company did not employ capital budgeting techniques. Therefore, Person B has hired Person X to determine the cost of capital of Company H. As Company H is a private company, it is not easy to determine the cost of equity. Hence, Person B suggests the use of pure play approach to determine the cost of capital. He wants Person X to refer the financials of Company D to determine its cost of capital.

Characters in the case:

• Company H: The character attempting to determine an appropriate cost of capital
• Person B: The founder of Company S
• Person X: The analyst hired by Company S
• Company D: A pure play company

Introduction:

The cost of equity refers to the return that the equity shareholders expect on an equity capital.

To determine: The cost of equity using the Security market line (SML) approach