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

a) Beta od asset is given as = Beta of equity/(1+Debt/ Equity*(1- tax rate))

For ian Finest Motor cycles

Beta of equity =1.9

Debt equity ratio = 0.7

tax rate = 35%

Hence beta of asset= 1.9/(1+0.7*(1-35%))

=1.9/(1+0.7*0.65)

= 1.9/(1+0.455)

=1.9/1.455

= 1.305842

b) Unlevered cost of equity = Risk free rate +Beta of asset*( Market rate of return- Risk free rate)

=3%+ 1.305842*(15%-3%)

=3%+1.305842*(12%)

=3%+15.6701%

=18.6701%

c) Equity beta of my firm = Beta of asset *(1+Debt/ Equity*(1-tax rate))

Given Debt =60%

Equity = 40%

Hence debt/ equity= 60% /40%= 1.5

Hence equity beta= 1.305842*(1+1.5*(1-35%))

=1.305842*(1+1.5*(65%))

=1.305842*1.975

=2.579038

d) Given cost of debt = 6%

Post tax cost of debt =6%*(1- tax rate)

=6%*(1-35%)

=6%*65%

=3.9%

For cost of equity

Beta =2.579038

Hence cost of equity = Risk free rate +Beta of Company*( Market rate of return- Risk free rate)

=3%+2.579038*(15%-3%)

=3%+2.579038*12%

=3%+30.9485%

=33.9485%

Hence WACC= Weight of debt * Post tax cost of debt+ Weight of equity * Cost of equity

=60%*3.9%+40%*33.9485%

= 2.34%+12.3794

= 14.7194%

e) Present value of inflows in next 12 years = CF1/(1+ WACC)^1+CF2/(1+ WACC)^2+CF3/(1+ WACC)^3+....+CF12/(1+ WACC)^12

=1/(1+14.7194%)^1+1/(1+14.7194%)^2+1/(1+14.7194%)^3+.....+1/(1+14.7194%)^12

=1*Present value of annuity factor at 14.7194% for 12 years

=1*5.49

=5.49 Millions

NPV= Present value of inflows - present value of outflows

Given present value of outflows= 5 Millions

Hence NPV = 5.49-5=0.49 Millions