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%

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

given debt 0.7

equity 1

equity beta is 1.9

debt beta is 0

=1.9*0.6873

asset beta =1.31

and

cost of equity of unleverd firm =risk free rate + beta(market rate- risk free rate)

=3%+1.31(15%-3%)

=18.72%

b)your asset beta is 1.31

given 40 % equity and debt is 40%

let equitt beta is x

1.31=x*0.5063

x=2.59

equity beta is 2.59

c)wacc = weight of equity*cost of equity+ weight of debt* cost debt after tax

cost of equity of levered firm=risk free rate + beta(market rate- risk free rate)

=3%+2.59(15%-3%)

=34.08%

cost of debt is risk free rate i.e 3%

wacc= 0.4*34.08%+0.6*3%(1-0.35)

=13.62%+1.17%

=14.80%

D) cashflows= ebit(1-tax)+deprciation

=1M(1-0.35)+5M/12 years

=0.65+0.42

=1.067M

npv = present value of cashinflow- present value of cashoutlfows

=1.067M *PVAF(14.8%, 12 )- $ 5M

=1.067M*5.4672- $5M

=5.8317M-5m

$0.8317 m