Question

Super Bikes (SB) Inc. is a company which manufactures bicycles and distributes to retailers across Canada. Its line of business is generally considered quite stable and low risk. SB Inc. would like to invest in a new division to manufacture skateboards.

Currently, SB Inc. has a cost of debt (before tax) of 5% and its stock has a beta of 0.6. The firm’s debt-equity ratio is 0.7. The firm has identified another company (Free Wheels Inc) whose main business is similar to this project. Free Wheels Inc. has a cost of debt (before tax) of 8%, a beta of 2.5, tax rate of 35% and a debt-equity ratio of 0.4.

SB Inc.has an effective tax rate of 35%. The expected return on the market is 10% and the risk free rate of interest is 4%.

What is the appropriate cost of capital to apply to SB Inc.’s proposed expansion into the skateboard manufacturing business?

Answer 1

The appropriate cost of capital for SB's proposed expansion into the skateboard manufacturing business would be the wacc for FreeWheels Inc. WACC for SB Inc would also include risk about bicycles business which may not correctly captire the risk on skateboard business.

WACC = Weight of debt * Cost of Debt * (1 - Tax rate) + Weight of Equity * Cost of Equity

We would use the cost of capital as that of FreeWheels, but weights would be used as per the SB Inc's capital structure.

For cost of equity let us use the CAPM equation , according to which

Cost of Equity = Risk free rate + Beta * (Expected market return - Risk free rate)

For Beta of Freewheels, we need to unlever it and re-lever it based on SB Inc. capital structure.

We will use the mathematical relation for this:

Now, we need to re-lever it using D/E ratio of SB Inc, which is 0.7

Cost of Equity using CAPM = 4% + 2.89 * (10% - 4%) = 4% + 17.32% = 21.32%

D/E = 0.7 => Weight of debt = 0.7, Weight of Equity = 1

WACC = 0.7 * 8% * (1 - 35%) + 1 * 21.32%

WACC = 3.64% + 21.32% = 24.96% ---> Answer