Hydra Multinational is a vast conglomerate firm involved in a wide array of business ventures ranging from satellite radio to cat food. One of its many divisions, a restaurant chain, is considering the value in trying to push its brand into a new geographical market and thus needs to estimate the appropriate cost of capital for this highly complex project. To help in your analysis, your junior analysts gathered some relevant data for you:
Hydra has $11.3 billion in debt outstanding, a market capitalization of $26 billion, and its average tax rate is 34%. New bonds would have to be issued with a 6.74% coupon rate while there is sufficient retained earnings to pay for the expansion (internal equity will be allocated such that the capital structure will not change).
The closest market competitor for the restaurant chain, Extra Chicken, has a beta of 1.8 with the broad market. Its most recent bond sale (still trading very close to par) offered a 7.8% coupon rate and it also faces a 34% tax rate. Their D/E ratio is 0.63. The risk-free rate is estimated to be an average of 3.2% for the appropriate time horizon and the market risk premium is estimated to be 6.7% over the coming years.
a) What cost of capital should be applied to Hydra's restaurant chain expansion plan?
b) Why would the discounted payback approach not be an appropriate way to evaluate such a project? What important information is missing from that kind of analysis?
c) What does it mean when we assume that two firm's have the same business risk?