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:

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 U.S.-based business intelligence software company. The
industry has grown at 26 percent per year for the previous three years. Large companies
dominate the market, but sizable “pure-play” 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 U.S. 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. Other information that Duarte has gathered:
Currently outstanding bonds $2.4 million five-year bonds, coupon of 12.5 percent,
with a market value of $2.156 million
Risk-free rate of interest 5.25%
Estimated equity risk premium 7%
Tax rate 23%
A. 20.5%.
B. 21.0%.
C. 21.5%.

Answer: C. 21.5%.