Problem 7 (15 points) You are considering opening a bagel need to work out a fin
ID: 2657851 • Letter: P
Question
Problem 7 (15 points) You are considering opening a bagel 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 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%. shop in the town center and information you collected for the o) What is the cost of levered equity of Universal Bagel? (2) What is the unlevered cost of capital for Universal Bagel? ) What 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 ratio of 0.5. What is the after-tax WACC of your bagel shop?Explanation / Answer
1- Levered Cost of equity of Universal Bagel = Risk-Free Rate + Beta * (Market Risk Premium
= .05 + 0.85 *.08 = 11.8 %
2- Unlevered Cost of Equity of universal bagel = Risk-Free Rate + Unlevered Beta (Market Risk Premium)
BetaU= BetaL/ ( [ 1+ (1- T) *(D/E)]
BetaU = Unlevered Beta, BetaL (Beta)= Unlevered Beta
BetaU = 0.85 / (1 + (1- 0.4)*1.5) = 0.85 / (1+ 0.9) = 0.78
Unlevered Cost Of equity = 0.05 + 0.78 * 0.08 = 0.1124 = 11.24%
Unlevered Cost of capital Univerasl Bagel = (Equity / Debt + Equity) * Unlevered cost of Equity + (Debt / Debt + Equity) * Cost of Debt * (1- tax rate)
Universal Bagel :Debt / Equity = 1.5; Debt 9D) = 1.5 * Equity (E)
Cost of Capital Universal Bagel = (E / (1.5E + E))*.1124 + (D/(D +(D/1.5)) * .06 * (1-.4)
= (1/2.5)*.1124 + (1.5/2.5) *.06*0.6 = .04496 + .036 = 0.06656= 6.6%
3- Assuming Debt / Equity ratio as same:
All remaing same except cost of debt = 5.67%
My Unlevered Cost of Capital = (1/2.5)*.1124 + (1.5/2.5) *0.0567 *0.4 = 0.0653 = 6.5%
4- D/E = 0.5, Cost of eqiuity = Levered Cost of equity of Universal Bagel = 11.8%, Cost of Debt = 5.67%
Tax Rate = 40%
WACC = (Equity / Debt + Equity) * Cost of Equity + (Debt / Debt + Equity) * Cost of Debt * (1- tax rate)
= E/ (E+0.5E) *0.1124 + (0.5E/(0.5E +E) * 0.0567 * (1-0.4)
= (1/1.5)*0.1124 +(0.5/1.5) *.0567 * 0.6
= 0.0749 + 0.01134 = 0.08624 = 8.6 %
5- My Cost of eqiuity = Levered Cost of equity of Universal Bagel = 11.8%