Question

You are considering starting a company that manufactures racing bicycles. You are planning on financing your firm 40% equity and 60% debt. You estimate that your upfront costs will be $5M, and that you will earn an EBIT of $1M per year for the next 12 years. Lightning Bolt Bikes makes racing bicycles similar to the ones that you wish to manufacture. They have a CAPM equity beta of 1.9 and a debt to equity ratio of 0.7. The tax rate for both firms is 35%, the riskless rate is 3%, and the expected return on the S&P500 is 15%. Cost of Debt is 6%

2 What is your unlevered cost of equity?

3 What is your firm’s equity beta?

4. What is your firm’s weighted average cost of capital?

5 What is the NPV of your proposed bicycle company using the WACC method?

Answer 1

Unlevered beta = 1.9 / [1 + (1 - 0.35) * 0.70] = 1.306

Answer 2

Unlevered cost of equity = Risk-free rate + [Unlevered beta * (Expected return on market - Risk-free rate)]

= 3.00% + [1.306 * (15% - 3%)]

= 18.672%

Answer 3

Equity beta = 1.306 * [1 + (1 - 0.35) * (0.60 / 0.40)]

= 2.58

Answer 4

Cost of equity = 3.00% + [2.58 * (15% - 3%)] = 33.96%

After-tax cost of debt = 6% * (1 - 35%) = 3.90%

Weighted average cost of capital (WACC) = (33.96% * 40%) + (3.90% * 60%) = 15.924%

Answer 5

Total debt = $5,000,000 * 60% = $3,000,000

Interest = $3,000,000 * 6% = $180,000

Cash flow after-tax = ($1,000,000 - $180,000) * (1 - 35%) = $533,000

Net present value = [$533,000 * (1 - (1.15924)^-12) / 0.15924] - $1,000,000 = $1,778,826.60