Question

Estimating the WACC using a surrogate firm

C2. (Estimating the WACC using a surrogate firm) Dyl Pickle is a new firm in the condiment business. Dyl has $25 million in debt and its equity is worth an estimated$50 million. Because Dyl is not publicly traded, it is unsure of its cost of capital and cost of equity. Dyl considers Mercado Products to be very similar to itselfand will use Mercado as a surrogate firm to estimate its own WACC. Mercado’s equity beta is 1.40, its leverage ratio is 40%, and its marginal tax rate is 34%. Dyl’stax rate is also 34%.
a. Estimate Mercado’s and Dyl’s asset beta.
b. Estimate Dyl’s equity beta.
c. Assuming a riskless return of 6% and an expected return on the market of 14%, what
should be Dyl Pickle’s cost of capital and cost of equity?

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