You and your friends have decided to examine the potential of starting a series
ID: 2756487 • Letter: Y
Question
You and your friends have decided to examine the potential of starting a series of restaurants in and around college campuses in Boston that cater exclusively to students. Assume that (together) you have $120,000 (equity) for this project which requires an initial investment of $200,000. The remaining amount of $ 80,000 can be raised through issuing bonds. You are given the following additional information about the project.
Year
Free Cash Flow
1
$ 20,000
2
$ 40,000
3
$ 60,000
4
$ 80,000
5
$ 100,000
Other Information
Beta based on similar businesses
2.00
Risk Free Rate
4.50% / year
Market Risk Premium
8.00% / year
Price per Bond
$ 1,050
Face Value of Bonds
$ 1,000
Coupon Rate on Bonds
8.50 %
Coupons Paid
Monthly
Maturity of Bonds
5 years
Tax rate for firm
30%
Year
Free Cash Flow
1
$ 20,000
2
$ 40,000
3
$ 60,000
4
$ 80,000
5
$ 100,000
Other Information
Beta based on similar businesses
2.00
Risk Free Rate
4.50% / year
Market Risk Premium
8.00% / year
Price per Bond
$ 1,050
Face Value of Bonds
$ 1,000
Coupon Rate on Bonds
8.50 %
Coupons Paid
Monthly
Maturity of Bonds
5 years
Tax rate for firm
30%
Explanation / Answer
Given The Project requires $ 200000 which will be financed by Debt( Bonds) of $ 80000 & Equity $ 120000 Given beta of business =2 "==> 2 = We( Beta of Equity) + Wd ( Beta of debt) ==> 2= 1.2/2*(beta of Equity) + 0.8/2*(0) ==> Beta of Equity = 3.33 By using CAPM model Cost of Equity(Ke) = Risk free Rate + Beta of Equity ( Market risk Premium) = 4.5% + 3.33( 8%) =31.14% Kd = 8.5% WACC= We(Ke) + Wd( Kd)(1- Tax rate) = 1.2/2*(31.14%) + 0.8/2 *(8.5%)(70%) =21% Year Free cash Flow Pv factor @ 21% Discounted Cash Flow 0 -200000 1 -200000 1 20000 0.826446 16528.93 2 40000 0.683013 27320.54 3 60000 0.564474 33868.44 4 80000 0.466507 37320.59 5 100000 0.385543 38554.33 NPV -46407.2 Since the NPV is Negetive it is not advisable to take up the project
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