Problem 7 (15 points) You are considering opening a bagel shop in the town cente
ID: 2657783 • Letter: P
Question
Problem 7 (15 points) You are considering opening a bagel shop in the town center and need to work out a financial plan. The first task you need to work on is to estimate the cost of capital of this opportunity. In order to help your estimation, you identified a public company, Universal Bagel, that has the same business model as the one that you are proposing. The information you collected for the estimation is as following: the D/E ratio of Universal is 1.5; the risk free rate is 5%; the market risk premium is 8%; the beta of Universal Bagel is 0.85; the cost of debt of the Universal Bagel is 6%; the cost of your debt is 5.67%; and the corporate tax rate is 40%. What is the cost of levered equity of Universal Bagel? What is the unlevered cost of capital for Universal Bagel? aWhat is the unlevered cost of capital for YOUR bagel shop? 4) Assume that as a start-up, you cannot borrow too much and you will have to maintain a D/E atio of 0.5. What is the after-tax WACC of your bagel shop?Explanation / Answer
Given that D/E Ratio of Universal 1.5 Risk free rate(Rf) 5% Market Premium(Rm-Rf) 8% Beta levered 0.85 Cost of debt of Universal 6% Cost of Bagel shop debt 5.67% Cost of Levered Equity of universal = Rf+ levered beta*(Rm-Rf) Re of Universal 11.8% Calculation of Un levered Cost of Capital of Universal(Ru): Unlevered Cost of Capital (Re) =Ru+(Ru-Rd)(1-tax)*D/E 11.8 = Ru+(Ru-6)(1-0.4)*1.5 Un levered Cost of Capital of Universal(Ru) 32.5% Calculation of unlivered Beta of Universal Beta unlivered = Beta Levered/(1+(D/E)(1-Tax)) Beta Unlivered of Universal 0.45 Calculation of Un levered Cost of Capital of Bagel Shop: Beta of Bagel shop = Unlevered beta of universal+Unlevered beta of universal(1-tax)*D/E 0.78 Unlevered cost of Capital of Bagel shop 11.3% Weighted Average cost of capital of Bagel shop 8%