6.

1 Risk and the Cost of Capital for a Project 151

APPLICATION: ESTIMATING CARBORUNDUM'S COST OF CAPITAL

In November 1977, Kennecott Copper Corporation was considering the acquisition of

the Carborundum Company. What discount rate should Kennecott have used to evalu-
ate this potential acquisition? Here are some facts:9
1. Carborundum's equity beta was estimated at 1.16.
2. The long-term Treasury bond rate at this time was 7.6%.
3. The historical spread (1926 through 1974) between returns on the S&P 500 index and on
long-term Treasury bonds was 7.5%.
4. The market value of Carborundum's equity was $271 million, and its market value of debt
was $86.2 million.
5. If Kennecott decided to go ahead with the acquisition, it would be financed in part by hav-
ing Carborundum issue an additional $100 million in debt followed immediately by pay-
ment of a $140 million dividend to Kennecott.
6. The cash flows being discounted by Kennecott were those it would receive from
Carborundum, net of financing costs.
On the basis of this information, we can calculate Carborundum's preacquisition
cost of equity capital as 16.3% (0.076 + 1.16 x 0.075). This discount rate is suitable for
evaluating Carborundum's cash flows to equity under its current capital structure. But
because the cash flows being discounted are the net flows to Kennecott, the appropriate
discount rate is Carborundum's cost of equity capital under its new capital structure.
This discount rate can be found by first unlevering Carborundum's equity beta under its
current capital structure and then relevering it to reflect the projected capital structure.
Using Equation 6.5 and assuming a marginal corporate tax rate at the time of 50%,
Carborundum's unlevered or asset beta can be estimated as

1.16 = 1.00
[1 + (1 — 0.5)86.2/271]

Under Kennecott's planned financial restructuring, Carborundum's debt:equity ratio

would rise from 0.32 to 1.42 [(86.2 + 100)/(271 – 140)]. According to Equation 6.6, this
increase in leverage would result in an equity beta for the recapitalized company equal to
1.00(1+0.5x1.42) = 1.71

Substituting a beta of 1.71 in Equation 6.1 yields an estimate of Carborundum's

cost of equity capital under its postacquisition capital structure equal to 20.4% (0.076 +
1.71 x 0.075).

9
The numbers and the issues raised come from "Valuing an Acquisition Candidate: Kennecott Copper
Corporation," in Keith Butters, J. et al. Case Problems in Finance, 8th ed. Richard D. Irwin: Homewood,
Ill., 1981.