American Chemical Corp Case Study

Part I (Cost of Equity):

Estimate the cost of equity appropriate for the evaluation of the incremental cash flows associated with the Collinsville investment. Please carefully explain.

Method:

To calculate an estimate of the cost of equity, we can use the following three methods:

1. The Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) uses the risk-free rate (kRF ) of return as a starting point for the firm’s cost of equity, a risk premium is then added to the risk-free rate to arrive at the firm’s estimated cost of equity. The risk premium is a function of the firm’s risk remaining after diversification.

The CAPM equation is as follows:

Ke=KRF+BL(KM- KRF)

In the above equation, KRF is the risk-free return, BL is the firm’s beta value (a measure of risk), and (KM- KRF) is the Market Risk Premium or the difference between the return on the market and the risk-free rate.

To adjust the cost of equity for changes in financial risk, the Hamada Equation can be utilized. The Hamada Equation allows for adjustments to the beta of a firm for different levels of financial risk, the adjusted betas can then be used in the CAPM to reflect the effects that different debt-to-equity levels will have on the cost of equity.

The Hamada equation is shown below:

BL=BU [1+(1+T)(D/E)]

In the equation above, BL is the current, leveraged beta of the firm and BU is the firm’s unleveraged beta (i.e., the firm’s beta assuming the firm is funded with 100% equity). In this equation, BU is multiplied by the firm’s tax adjusted debt-to-equity ratio, which gives BL. By altering the firm’s debt-to-equity ratio, beta can be calculated for all levels of debt.

Furthermore, beta values calculated using the Hamada Equation are useful when comparing the risk levels of two firms with different capital structures. This is because beta can be used to adjust the cost of equity for different levels of debt in the WACC model, and then the firms...