Question

Smalltalk is a social media company that is considering expanding into online retailing. The project, which is estimated to last 4 years, requires an initial investment of £20m in year zero. Sales and operating costs are estimated to be £30m and £20m, respectively, in each of years 1-4. Working capital is expected to be £10m in year 1, doubling to £20m in year 2 and growing to £30m in year 3, before falling back to zero in year 4. Smalltalk has a Debt/Equity (D/E) ratio equal to one. Assume that the company is able to borrow at the risk free rate of 5% and that the market risk premium is 8%. Assume also no taxes and that all cash flows accrue at the end of the relevant period.

a. Determine Smalltalk’s cost of capital and the NPV of the project assuming that the project has the same capital structure as the company and an equity beta equal to 2.

b. Suppose now that the equity beta of social media firms is 4 and the equity beta of online retailers is 1. Determine the appropriate cost of capital and the NPV of the project, explaining the logic behind your choice of beta. (Assume for simplicity that D/E ratios in the two industries are similar to the project’s D/E)

c. Assume now that, different from b., Smalltalk has a unique capital structure among both social media companies and online retailers. The average D/E ratio in both industries is around 0.5 while Smalltalk’s is 1. Provide a brief discussion of how you would revise your analysis in b. to account for this piece of information

Answer 1

a.Weight of debt = weight of equity = 0.5 (since debt/equity = 1)

Cost of debt = 5%

Cost of equity = 5+ 2*8 = 21%

WACC = 0.5*5 +0.5*21 = 13%

Cost of capital = 13%

NPV calculation is as shown below:

The working capital is 10 Million in year 1, in Year 2 an additional 10 Million is required (total 20 Million), and in year 3, a further additional 10 million is required (total 30 Million) and in year, 30 million is released back since we require 0 working capital in year 4

Year	0	1	2	3	4
Initial investment	-20
Working Capital		-10	-10	-10	30
Sales		30	30	30	30
Cost		-20	-20	-20	-20
Net Cash flow	-20	0	0	0	40

NPV = 40/1.13^4 -20 = 4.53 Million

NPV = 4.53 Million

b. Since Smalltalk is a social media company expanding online, we take equity beta to be the average of the two betas, (4+1)/2 = 5/2= 2.5

Cost of equity = 5+ 2.5*8 = 25%

Cost of capital = 0.5*5 +0.5*25 = 15%

NPV = 40/1.15^4 - 20 = 2.87 Million

c. Small talk has a higher D/E =1 , means Smalltalk has a higher component of debt when compared to that of the industry. Other forms within the industry have lower debt. So, because of higher debt, Smalltalk should have a higher bankruptcy costs and I would increase the cost of capital from what we got in (b).