Question 13.6: You are working for Microsoft evaluating the possibility of ...
You are working for Microsoft evaluating the possibility of selling digital video recorders (DVRs). Microsoft’s WACC is 8.6%. DVRs would be a new line of business for Microsoft, however, so the systematic risk of this business would likely differ from the systematic risk of Microsoft’s current business. As a result, the assets of this new business should have a different cost of capital. You need to find the cost of capital for the DVR business. Assuming that the risk-free rate is 3% and the market risk premium is 6%, how would you estimate the cost of capital for this type of Investment?
PLAN
The first step is to identify a company operating in Microsoft’s targeted line of business. TIVo, Inc., is a well- known marketer of DVRs. In fact, that is Its sole business. Thus, the cost of capital for TIVo would be a good estimate of the cost of capital for Microsoft’s proposed DVR business. Many Web sites are available that provide betas for traded stocks, including http://finance.yahoo.com. Suppose you visit that site and find that the beta of TiVo stock is 1.45. With this beta, the risk-free rate, and the market risk premium, you can use the CAPM to estimate the cost of equity for TiVo. Fortunately for us, TiVo has no debt, so its cost of equity is the same as its cost of capital for its assets.
EXECUTE
Using the CAPM, we have
TiVo’s Cost of Equity = Risk-Free Rate + TiVo’s Equity Beta × Market Risk Premium = 3%+ 1.45 × 6% = 11.7%
Because TiVo has no debt, its WACC is equivalent to its cost of equity.
EVALUATE
The correct cost of capital for evaluating a DVR investment opportunity is 11.7%. If we had used the 8.6% cost of capital that Is associated with Microsoft’s existing business, we would have mistakenly used too low of a cost of capital. That could lead us to go ahead with the investment, even if it truly had a negative NPV.