Problem 7 (15 points) You are considering opening a bagel need to work out a fin
ID: 2657881 • 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. Th 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 e 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? a) 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
a) Cost of Levered equity : - with example we can understand cost of levered equity- e.g The cost of unlevered equity is 15% for the firm with no debt, but rises to 18% for the firm with some debt. this additional cost of equity capital due to the fact that the firm adding leverage increases the risk to equity holders.
CAPM : Risk free return + Beta* Risk Premium
ke - 5% + 0.85*8%=11.8%
kd =6%
debt equity ratio - 1.5
WACC = 1*11.8+6 (1-.40)*1.5 = 17.20%
cost of levered equity of universal bagel - 17.20%
b)
CAPM : Risk free return + Beta* Risk Premium
ke - 5% + 0.85*8%=11.8%
unlevered cost of capital of universal bagel - 11.8%
c) unlevered cost of capital of our bagel shop is same as universal bagel shop i.e - 11.8%
d) when we have to maintain debt equty ration 0.5
then, WACC = 1*11.8+0.5(5.67(1-.40)) - 13.50%