Boris Duarte, CFA, covers initial public offerings for Zellweger Analytics, an independent research firm specializing in global small-cap equities. He has been asked to evaluate the upcoming new issue of TagOn, a US-based business intelligence software company. The industry has grown at 26% per year for the previous three years. Large companies dominate the market, but sizable comparable companies, such as Relevant Ltd., ABJ Inc., and Opus Software Pvt. Ltd., also compete. Each of these competitors is domiciled in a different country, but they all have shares of stock that trade on the US NASDAQ. The debt ratio of the industry has risen slightly in recent years.
Company | Sales in Millions ($) | Market Value Equity in Millions ($) | Market Value Debt in Millions ($) | Equity Beta | Tax Rate (%) | Share Price ($) |
Relevant Ltd. | 752 | 3,800 | 0.0 | 1.702 | 23 | 42 |
ABJ Inc. | 843 | 2,150 | 6.5 | 2.800 | 23 | 24 |
Opus Software Pvt. Ltd. | 211 | 972 | 13.0 | 3.400 | 23 | 13 |
Duarte uses the information from the preliminary prospectus for TagOn’s initial offering. The company intends to issue 1 million new shares. In his conversation with the investment bankers for the deal, he concludes the offering price will be between $7 and $12. The current capital structure of TagOn consists of a $2.4 million five-year noncallable bond issue and 1 million common shares. The following table includes other information that Duarte has gathered:
Currently outstanding bonds | $2.4 million five-year bonds, coupon of 12.5% paying semi-annually with a market value of $2.156 million |
Risk-free rate of interest | 5.25% |
Estimated equity risk premium | 7% |
Tax rate | 23% |
Q. The marginal cost of capital for TagOn, based on an average asset beta of 2.27 for the industry and assuming that new stock can be issued at $8 per share, is closest to:
Answer is option C ??
Can U Explain?