Question

Sunset Sarsaparilla is building a new bottling plant. This plant will cost $140M to construct, and will produce EBIT of $19M per year for the next 12 years. Sunset has a tax rate of 40%. Another firm in the same industry, Vim Pop, has an equity beta of 1.2 and a debt to equity ratio of 0.9. Sunset's debt to equity ratio is 1.5, the risk free rate is 4%, and the excess return on the market is 8%. Assume both firms can borrow at 5.5%.

1A. Find Sunset's equity beta using Vim as a comparable firm.

1B. Estimate Sunset Sarsaparilla's cost of levered equity

1C. Using this estimated cost of equity, find the NPV of opening this bottling plant using the WACC method.

Answer 1

1 A

Unlevered beta of Vim pop = levered beta/ (1+ (1-tax rate)*D/E)

= 1.2/(1+0.6*0.9) = 0.779221 (assuming tax rate to be same)

As the unlevered beta of comparable firms can be assumed to be the same

Unlevered beta of Sunset = 0.779221

Levered beta of Sunset = Unlevered beta* (1+(1-tax rate)*D/E)

=0.779221*(1+0.6*1.5)

=1.48

1 B. From CAPM,

Sunset Sarsaparilla's cost of levered equity = risk free rate + Beta * market risk premium

= 4%+1.48*8% = 15.84%

1 C.

D/E= 1.5 , so weight of Debt = 1.5/2.5 =0.6 and weight of equity = 0.4

So WACC = 0.6*5.5%*(1-0.4) + 0.4*15.84%

= 0.08316 or 8.316%

After tax cashflows every year = $19M* (1-0.4) = $11.4 M

So,
NPV = -140M+ 11.4M/1.08316+ 11.4M/1.08316^2+...+11.4M/1.08316^12

= -$55.47 M