The company’s stock is hundred percent owned by its several cofounders, and the
ID: 2712110 • Letter: T
Question
The company’s stock is hundred percent owned by its several cofounders, and the current market price of each of the 500,000 shares of stock is $20.
When you started your work, you were immediately assigned a big project. You were asked to evaluate a new investment project: opening a new “Coffee Cup” location in Pomona. Specifically, you were asked to analyze the projected sales revenues and costs and advise your boss on whether the project could be profitable. Below is the information regarding the project:
Project life
6 years
Initial investment raised solely from equity
$1,206,000
Number of “Coffee Cup” customers, per year
Out of this number, 75% are adults, and 25% are children.
100,000
Average price that an adult customer pays in year 1
This amount will be growing by $0.50 each following year
$6
Average price that a child customer pays each year
$3
Cost of preparing food and drinks and other variable costs, per each customer’s meal
$1
Equipment rental and other fixed costs, per year
$200,000
Systematic risk (i.e., Beta) of the project
1.17
Corporate tax rate is 34%. The project will fully depreciate on straight line over 6 years.
You also know that “Coffee Cup” has three main competitors in the coffee industry, also owned fully by their respective cofounders: Coffeebucks, Coffee Bean, and Pete’s Coffee. All but Coffeebucks are comparable in size to “Coffee Cup”, with Coffeebucks being roughly twice the size. Coffeebucks’ returns are not as prone to economy-wide up or downturns when compared to the returns on an average stock in the economy, and so its systematic risk, measured by Beta, is only 0.657. For Pete’s Coffee, though, the systematic risk is higher, with the Beta of 1.051, and it is even higher for Coffee Bean and equals 1.255. You did some research and figured out that the market risk of “Coffee Cup” reflects the average risk of the competitors.
Your boss also gave you some data – that might help you in your analysis – on annual returns of the US Treasury bills which are viewed as the riskless asset, as well as for the market portfolio proxied by Standard & Poor’s 500 index:
State of the economy
(all equally likely)
Annual returns (%)
Treasury bills
S&P 500
Boom
4
25
Normal
4
12
So-so
4
1
recession
4
-3
Question 2. (3 points) What is the weighted average cost of capital for the proposed investment project? Is the project as risky as the company? Calculate and explain.
Project life
6 years
Initial investment raised solely from equity
$1,206,000
Number of “Coffee Cup” customers, per year
Out of this number, 75% are adults, and 25% are children.
100,000
Average price that an adult customer pays in year 1
This amount will be growing by $0.50 each following year
$6
Average price that a child customer pays each year
$3
Cost of preparing food and drinks and other variable costs, per each customer’s meal
$1
Equipment rental and other fixed costs, per year
$200,000
Systematic risk (i.e., Beta) of the project
1.17
Explanation / Answer
Answer : Beta of the project = 1.17
beta of the company = Average of the beta of its three competetors ( As provided in Question)
= (0.657+1.051+1.255)/3
= 0.988
Weighted Average Cost of Capital on the investment
= risk free rate + project beta(( Average return on S&P - Risk free rate )
= 0.04 + 1.17((0.25+0.12+0.01-0.03)/4)-0.04)
= 0.956 or 9.56%
The project is riskier than the company as the project Beta is higher than the comany beta.
Calculation of depreciation per year
=1206000/6
=201000
NPV = 1200759.47-1206000
=-5240.53
Thus we can see that the project would be profitable but would not provide the required rate of return as per the projects beta.
Year 1 2 3 4 5 6 Particulars Average price per adult Customer 6 6.5 7 7.5 8 8.5 Number of adult customers 75000 75000 75000 75000 75000 75000 Revenue from adult customers 450000 487500 525000 562500 600000 637500 Average price per child coustomer 3 3 3 3 3 3 Number of children custmers 25000 25000 25000 25000 25000 25000 Revenue from child customers 75000 75000 75000 75000 75000 75000 Total revenue 525000 562500 600000 637500 675000 712500 Less Variable costs Cost of each customer meal (100000*1) 100000 100000 100000 100000 100000 100000 Less Fixed Costs Equipment rental and other FC per year 200000 200000 200000 200000 200000 200000 Depreciation 201000 201000 201000 201000 201000 201000 PBT 24000 61500 99000 136500 174000 211500 Less Tax @34% 8160 20910 33660 46410 59160 71910 PAT 15840 40590 65340 90090 114840 139590 Add Depreciation 201000 201000 201000 201000 201000 201000 CFAT 216840 241590 266340 291090 315840 340590 Present Value factor @wacc of 9.56% 0.912741877 0.833098 0.760403 0.694052 0.633490173 0.578213 Present Value of inflow 197918.9485 201268.1 202525.8 202031.5 200081.5 196933.6 Total Present Value of inflows 1,200,759.47