Question

Suppose the market cap of Tired Hands Brewery is $40 million and the market value of its debt is $10 million. Assume that the company's stock has a beta of 1.2 and its debt is risk free. The current T-bill rate is 5%, the expected market risk premium is 10%, and the marginal tax rate is 40%. Tired Hands is deciding between two mutually exclusive projects. The company could either invest in an expansion project that involves setting up a brewery in Massachusetts or a diversification project that involves the manufacture and sale of potato chips. There are two comparable “pure-play” firms that are solely engaged in the manufacture of potato chips: i) Baked Chip Co, which has no debt in its capital structure and has an equity beta of 0.9 and ii) Fried Chip Co, which has a debt to firm-value ratio of 0.1, an equity beta of 0.92, and a debt beta of 0.2. What discount rate should Tired Hands use when deciding whether or not to invest in the Massachusetts brewery project? Assume debt interest payments are tax deductible.

Answer 1

Tired Hands Brewery is already in the brewery business and it wants to invest in an expansion project of setting up a brewery in Massachusetts. Tired Hands should use its weighted average cost of capital (WACC) as discount rate for Massachusetts brewery project.

WACC = market value weight of debt*cost of debt*(1-tax rate) + market value weight of equity*cost of equity

market value weight of debt = market value of debt/(market value of debt + market value of equity)

market value weight of equity = market value of equity/(market value of debt + market value of equity)

market value weight of debt = $10 million/($10 million + $40 million) = $10 million/$50 million = 0.2 or 20%

market value weight of equity = $40 million/($10 million + $40 million) = $40 million/$50 million = 0.8 or 80%

Tired Hands' debt is risk free. so, its cost of debt is risk-free rate which is current T-bill rate of 5%.

cost of equity = risk-free rate or T-bill rate + stock's beta*expected market risk premium

cost of equity = 5% + 1.2*10% = 5% + 12% = 17%

WACC = 0.2*5%*(1-0.40) + 0.8*17% = 0.2*5%*0.60 + 13.6% = 0.6% + 13.6% = 14.20%

Tired Hands should use 14.20% discount rate when deciding whether or not to invest in the Massachusetts brewery project.