Question

You are considering starting a company that manufactures motorcycles. 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. Ian's Finest motorcycles make motorcycles 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%. Your cost of debt is 6%.

A). What is the asset beta of Ian's Finest motorcycles?

B). What is your unlevered cost of equity?

C). What is your firm’s equity beta?

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

E). What is the NPV of your proposed motorcycle company using the WACC method?

Answer 1

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))

Project 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%

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 = 0.159192 or 15.92%

NPV = -Initial Investment + 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