Chapter 14, Problem 3M

Summary Introduction

Case summary:

Company S is a privately held motor company. Person J, the owner of Company S 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 J has hired Person X to determine the cost of capital of Company S. As Company S is a private company, it is difficult to determine the cost of equity. Hence, Person J suggests the use of pure play approach to determine the cost of capital. He wants Person X to refer the financials of Company T to determine its cost of capital.

Characters in the case:

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

To determine: The cost of debt.

Introduction:

The cost of debt refers to the return that the bondholders or lenders expect on their principal. In other words, it refers to the borrowing costs of the company.