Question

You are considering starting a company that manufactures racing bicycles. You are planning on financing your firm 40% equity and 60% debt. You estimate that your upfront costs will be $5M, and that you will earn an EBIT of $1M per year for the next 12 years. Lightning Bolt Bikes makes racing bicycles similar to the ones that you wish to manufacture. They have a CAPM equity beta of 1.9 and a debt to equity ratio of 0.7. The tax rate for both firms is 35%, the riskless rate is 3%, and the expected return on the S&P500 is 15% Cost of Debt 6%

What is your firm’s weighted average cost of capital?

What is the NPV of your proposed bicycle company using the WACC method?

Answer 1

1) Weighted average cost of capital (WACC) = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt * (1 - tax rate)

Weighted average cost of capital = 40% * 33.948% + 60% * 6% * (1 - 35%)

Weighted average cost of capital = 15.92%

Working notes:

Asset Beta = Equity beta of Ian's Finest motorcycles * (1 / (1 + ((1 - tax rate) * Debt / Equity)))

Asset Beta = 1.9 * (1 / (1 + ((1 - 35%) * 0.7)))

Asset Beta = 1.3058

Project Beta = Asset Beta * (1 + ((1 - tax rate) * Debt / Equity))

Beta = 1.3058 * (1 + ((1 - 35%) * (60% /40%)))  

Project Beta = 2.5790

Firm’s equity beta = 2.5790

Cost of Equity = Risk free rate + Project Beta * (Expected return on S&P 500 - Risk free rate)

Cost of Equity = 3% + 2.5790 * (15% - 3%)

Cost of Equity = 33.948%

2)

NPV = -Initial Investment or out flow + Cash flow per year / (1 + WACC)¹ + ... + Cash flow per year / (1 + WACC)¹²

NPV = -$5,000,000 + $1,000,000 / (1 + 15.92%) +...+ $1,000,000 / (1 + 15.92%)¹²

Using PVIFA = ((1 - (1 + interest rate)^{- no of periods}) / interest rate) to value the cash flows

NPV = -$5,000,000 + $1,000,000* ((1 - (1 + 15.92%)^-12) / 15.92%)

NPV = -$5,000,000 + $5,214,426.57

NPV = $214,426.57