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

Solutions

Equity beta calculation of Sunset Sarsaparilla

Equity Beta = Asset beta × (1 + (Debt equity × (1- tax)

                        = 1.2 × (1 + (1.5 × (1 – 40%)

                        = 1.2 × (1 + (1.5 × 0.60)

                        = 1.2 × (1+ 0.9) = 1.2 × 1.9

                        = 2.28

Cost of equity calculation of Sunset Sarsaparilla

Capital Asset Pricing Model (CAPM) is used for calculation

Formula – (R_f +β) × (ER_m – R_f)

R_f - Risk free return

β - Beta

ER_m - Market rate of return

= (4% + 2.28) × (8% - 4%)

= (0.04 + 2.28) × (0.08 – 0.04)

= 2.32 × 0.04 = 0.0928

= 9.28%

NPV calculation by using the WACC (weighted average cost of capital)

Formula - Cost of equity + Cost of debt after tax

                        9.28% + 5.5(1-40%)

                        = 9.28 + 5.5(0.60)

                        = 9.28 + 3.30 = 12.58%