Question

StarDucks, Inc (SDUX) is an American coffee company with more than 10,000 coffeehouses operating in the United States. Unlike many of its major competitors, it remained focused only on the production and sale of coffee drinks so far, rather than diversifying into other similar food and beverage lines. Recently, to respond to increasing demands from its customer regarding new products, and to boost the company’s growth, the executive staff has been seriously thinking about entering into a different business line “SDUX Gelato” to realize new growth opportunities.
An initial forecasting effort has been done to project the initial investment and subsequent cash flows for the next 5 years:
Year	0	1	2	3	4	5
Cash Flow ($000s)	-1,750,000	-150,000	420,000	550,000	200,000	125,000
After the initial 5 years, SDUX believes the market will continue in perpetuity: however, given that the segment will reach maturity, it would very likely be a zero growth business. The company uses NPV for capital budgeting decisions on new products and investments.
As of today, SDUX currently has $8 billion in bonds (debt) outstanding. Their stock closed at $40/share and there are 300 million shares outstanding. The beta of SDUX stock (equity) is approximately 0.8. SDUX is an “A-rated’ company credit-wise, and continues to borrow at the current rate of 3.1% like most companies in that rating category. They face a marginal tax rate of 35%. Recent market data shows that 10-year US treasuries yield 1.8% and the expected market risk premium going forward is 6%.
Additionally, in considering the new investment, SDUX is likely going to raise new capital which it will finance through an equity offering. Based on the recommendation by their investment bank, SDUX considers establishing a new capital structure that will be 75% equity if they decide to go forward with the new business.
SDUX has also identified a pure play company, G-Latte-O Corp, that only produces and sells high end coffee-flavored gelato products. G-Latte-O has a capital structure that is 15% debt – 85% equity and has an equity beta of 1.4. They have the same marginal tax rate as SDUX.
a) Calculate the current WACC for SDUX Corporation and determine whether the company should proceed with the investment at that discount rate.
b) Calculate the appropriate risk-adjusted discount rate that SDUX should use to evaluate the new investment, and then determine whether the company should proceed with the investment using this risk-adjusted rate.

Answer 1

a]

WACC = (weight of debt * cost of debt) + (weight of equity * cost of equity)

cost of debt = borrowing rate * (1 - tax rate) = 3.1% * (1 - 35%) = 2.02%

cost of equity = risk free rate + (beta * market risk premium) = 1.8% + (0.8 * 6%) = 6.60%

value of debt = $8 billion

value of equity = $40 * 300 million = $12 billion

total value = $8 billion + $12 billion = $20 billion

weight of debt = value of debt / total value = $8 billion / $20 billion = 40%

weight of equity = value of equity / total value = $12 billion / $20 billion = 60%

WACC = (40% * 2.02%) + (60% * 6.60%) = 4.77%

At this discount rate, the present value of the cash flows are calculated as below :

present value of each cash flow = cash flow / (1 + discount rate)^year

The total of the present values of these cash flows is the NPV of the investment. At this discount rate, the NPV is negative. Hence the company should not proceed with this investment

b]

to calculate the risk-adjusted discount rate, we first calculate the unlevered beta of G-Latte-O Corp, and then re-lever the beta for SUDX

unlevered beta = levered beta / [1 + (1 - tax rate) * (debt / equity)]

unlevered beta = 1.4 / [1 + (1 - 0.35) * (0.15 / 0.85)] = 1.26

levered beta = unlevered beta * [1 + (1 - tax rate) * (debt / equity)]

levered beta for SUDX = 1.26 * [1 + (1 - 0.35) * (0.25 / 0.75)]

levered beta for SUDX = 1.53

risk adjusted cost of equity = risk free rate + (risk adjusted beta * market risk premium) = 1.8% + (1.53 * 6%) = 10.98%

The risk-adjusted cost of capital would be higher now than the current WACC. With the current WACC, the investment had a negative NPV. With the higher risk-adjusted discount rate, the NPV of the investment would be even lower. Hence the company should not proceed with the investment