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 is 6%.

A.What is the asset beta of Lightning Bolt Bikes and your unlevered cost of equity?

B. What is your firm’s equity beta?

C. What is your firm's weighted average cost of capital?

D. Use WACC method to find NPV of your proposed bicycle company?

Answer 1

In the absens of relivent information I am assuming change in debt to equity ratio does not have any impact in cost of equity financing however few author's take asume 1 or 2 % point extra cost of equity due to higer debt.

A)
	debt	60%
	equity	40%
	debt equity ratio (60%/40%)	1.50
	cost of equity for ligtnig bolt ltd	25.800%
	(beta of co(market rate-risk free rate))+risk free rate	1.9*(15%-3%)+3%
	cost of Debt for the lighting co.	3.90%
	cost*(1-taxrate)
B)	In the absens of relivent information I am assuming higher debt is not effect cost of equity finance
	Hence the cost of the equity and Beta will be same
	Beta shall be 1.9 and cost of equity shall be 25.8 %
C)	Weighted average cost of capital	12.66%
	(3.9%*60%)+(25.8%*40%)
d)	INITIAL INVESTMENT	$              50,00,000.00
	PRESENT VALUE OF 1 MILLION FOR NEXT 12 YEARS@ 12.66%	$              60,09,470.57
	PV(12.66%,12,-1000000)
	NET PRESENT VALUE OF THE PROJECT	$              10,09,470.57
	(6009470.57-5000000)