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Old exam question on project cost of capital WITH SOLUTION.pdf

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Boston College
MFIN 1127
Jerome Taillard

Q9 Project cost of capital (25 points = 7+2+4+12) BC Bean Corporation is in the business of selling premium coffee beans. The BC Bean's equity has a beta of 1.25. Its current market value-based debt/equity ratio is 0.25 and its marginal tax rate is 30%. The risk-free rate is 3%, and the market risk premium is 10%. The spread on BC Bean’s debt is equal to 2%. In the fiscal year that just ended, its book value of total assets was equal to $80M and its shareholder’s book equity equal to $50M. a. Compute its current after-tax WACC. (7 points) Hint: Use CAPM for equity Solution: 1 points for the formula After-tax WACC = (D/(E+D))* R_debt*(1-tax_rate) + (E/(E+D))*R_equity 1 point for the cost of debt R_debt = 3%+2%=5% 2 points for the CAPM computations For equity, you can use the CAPM : The market risk premium is equal to 10%. R_equity = rf + beta*(E(Rm)-rf) = rf = 3% +1.25*10% = 15.5% 2 points for the weights (the book value information is not relevant; I give the market value based debt to equity ratio D/E before): E/(E+D)= 1/(1+D/E) = 0.8 D/(E+D)= 1- (1/(1+D/E)) = 0.2 1 point for the final answer After-tax WACC = 0.2*5%*(1-0.3)+0.8*15.5% = 13.1% b. For what kind of project can it use its after-tax WACC as a hurdle rate when computing NPV? (2 points, 2 sentences max) Solution: It can use this hurdle rate for projects of similar risks to the current operations/assets and with the same financing structure. Equivalent: It would be a project in the business of selling premium coffee or a business that would have the exact same risk characteristics. It needs to have the same financing mix (debt/equity ratio) as we are in a setup where there are tax advantages of debt financing. BC Bean realizes it doesn’t have any sustainable competitive advantage in selling premium coffee. As a response, it intends to invest in a new venture that branches out into the restaurant business, where it feels it can have an edge over competition given its existing coffee business. It intends to have a target debt/equity ratio of 0.7 for this new venture. c. Give two reasons why it cannot use the current after-tax WACC for this new venture. (4 points, 2 sentences max per reason) Solution: One is that the new venture does not share the same risk characteristics of its current operations that sell premium coffee. The second reason is linked to the fact that the new operation is financed using much more debt which would alter the hurdl
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