Question

Barfly Inc. manufactures and markets a line of non-alcoholic mixers sold to restaurants and bars. Barfly’s Creative Bartender has recently experimented with making alcoholic versions with the intention of bottling and marketing these directly to the public through appropriate retail outlets. Prior spending on R&D was $1.5 million and Barfly anticipates spending half of that again during the first year of the project to conclude R&D (for total R&D of $2.25 million). The cost of building the manufacturing line is estimated at $1,175,000. Marketing projects revenues from the new product line will be 800,000 units in the first year, growth in years 2 and 3 at 15%, growth in year 4 at 10%, and 5% for year 5. While Barfly anticipates the product will have a longer life than 5 years, their initial projections are for a 5 year time horizon, fully depreciating the cost of plant and equipment over that time on a straight-line basis. Revenue per unit is projected to be $2.50 in the first year, with prices rising by 3% per year thereafter. COGS are projected to be 68% of revenues, SG&A 7% of revenues, and the company’s marginal tax rate is 32%. Net working capital required for the project is expected to be 2% of revenues annually once the project is fully online in year 1. Barfly’s balance sheet includes $3,000,000 in total capital, of which $980,000 is debt. The market yield to maturity on debt is 3.75%, the risk free rate on a 5-year Treasury is 3%, and the market risk premium is 6.5%. The company’s beta is 1.3 and the CFO uses the CAPM to estimate cost of equity.

Management has been studying the company’s capital structure and is considering using a small secondary offering of stock to pay down debt. The following data is used to determine the cost of debt under varying capital structures.

Debt ratio	Spread to Treasuries	Yield on Debt
0% - <10%	0.00%	3.000%
10% - < 20%	0.15%	3.150%
20% - < 30%	0.30%	3.300%
30% - < 40%	0.50%	3.500%
40% - < 50%	0.75%	3.750%
50% - < 60%	1.05%	4.050%
60% - < 70%	1.35%	4.350%
70% - < 80%	1.90%	4.900%
80% - < 90%	2.50%	5.500%
90% - < 100%	3.10%	6.100%
100% - < 110%	3.80%	6.800%
110% - < 120%	4.70%	7.700%
120% - < 130%	6.00%	9.000%
130% - < 140%	7.20%	10.200%
140% - < 150%	9.00%	12.000%
150% - < 160%	11.00%	14.000%

1. If Barfly issues $180,000 in new equity and uses the proceeds to repurchase (and defease*) existing debt, what would the resulting weighted average cost of capital be?

2)Should management move towards this capital structure? Why or why not?

Answer 1

Following are the data derived for the above scenario, based on which all financial will be derived:-

R&D	$1,500,000
Total R&D expenses	$2,250,000
Fixed cost	$1,175,000
Company tax rate	32%
Total Capital	$3,000,000.00
Total Debt	$980,000
Yield on Debt	3.75%
Risk Free Rate	3%
Market Risk Premium	6.50%
Beta	1.3
Net working capital requirement	2%	revenue every year
Debt Ratio	32.67%
Yield on Debt	3.50%	as debt lie between 30% to 40%

Profit and loss statement has been derived out of the given data:-

year	1	2	3	4	5
no of units	800000	920000	1058000	1163800	1221990
per unit cost	$2.50	$2.58	$2.65	$2.73	$2.81
Revenue	$2,000,000.00	$2,369,000.00	$2,806,080.50	$3,179,289.21	$3,438,401.28
COGS	$1,360,000.00	$1,610,920.00	$1,908,134.74	$2,161,916.66	$2,338,112.87
SG&A	$95,200.00	$112,764.40	$133,569.43	$151,334.17	$163,667.90
R&D expenses	$750,000	0	0	0	0
net working capital (debt)	$40,000.00	$47,380.00	$56,121.61	$63,585.78	$68,768.03
interest expenses	$1,400.00	$1,658.30	$1,964.26	$2,225.50	$2,406.88
total income	-$206,600.00	$643,657.30	$762,412.07	$863,812.88	$934,213.63
tax	FALSE	$210,282.84	$249,080.02	$282,207.67	$305,207.59
Profit after tax	0	$433,374.46	$513,332.05	$581,605.21	$629,006.04

From the above chart, we can easily see that for first year there will not be any profit because of high R&D expenses, but later years, barfly booked good amount of profit.

Scenario 1) If barfly issues $180,000 in new equity and uses the proceeds to repurchase existing debt, what would the resulting WACC?

Initially, Barflywas having debt to equity ratio of 32.67% but after repurchase of debt, current debt to equity ratio becomes 26.67%.

Weighted average cost of capital is mainly the cost of debt and cost of equity multiplied by the percentage of equity and debt employed into the company.

cost of debt can be derived by the table given above. In our case, Debt is 26.67% of total capital, so cost of debt is 3.30%.

Cost of equity for any company can be derived by the required rate of return on a particular project or investments.

BY using CAPM model, we can easily calculate cost of equity. Formula for CAPM is given below:-

Expected rate of return = risk free rate + beta*(expected return of market - risk free rate)

risk free rate	3%
market risk premium (expected return of market - risk free rate)	6.50%
beta	1.3

by putting above data into the CAPM equation, we get 11.45% as cost of equity.

year	1	2	3	4	5
DEBT	26.67%	26.67%	26.67%	26.67%	26.67%
EQUITY	73.33%	73.33%	73.33%	73.33%	73.33%
cost of debt	3.30%	3.30%	3.30%	3.30%	3.30%
cost of equity	11.45%	11.45%	11.45%	11.45%	11.45%
WACC	9.28%	9.28%	9.28%	9.28%	9.28%

B) Should management move towards this capital structure? why or why not?

sol:-by looking at the cost of equity, which is quite higher than the cost of debt, I suggest to take higher debt to minimize the wacc.