LilyMac Studios, a national chain of photography studios, is considering opening

Question

LilyMac Studios, a national chain of photography studios, is considering opening up a chain of coffee shop/ art galleries. While the existing operations of the firm have a beta of 1.17, the new chain is expected to have a beta of 0.8. LilyMac currently has 500,000 shares of common stock outstanding, which are selling for $ 63.72 per share, and a $ 10 million bond issue, selling at 104 percent of par. The expected market risk premium is 6 percent, and the current risk- free rate is 5.5 percent. The bonds pay an 8 percent semiannual coupon and mature in 20 years. The current operations of the firm produce EBIT of $ 18 million per year, and the chain’s operations are expected to add $ 25 million per year to that. The new chain will be funded with 65 percent equity and 35 percent debt, and estimated flotation costs are expected to be 12 percent and 5 percent, respectively. What should be the WACC for the new chain of coffee shops? Please explain what WACC is and show your work to find the WACC for the new chain of coffee shops.

Explanation / Answer

New Cost of Equity= Risk free +New beta*Risk premium=5.5+0.8*6=10.3%

Let YTM of debt=2r

104=4*Annuity factor (40 semi-annual periods, r %)+100/(1+r^40)

104=4*(1/r)*(1-1/(1+r^40))+ +100/(1+r^40)

By hit and trial r=3.8%

Thus YTM=2r=2*3.8=7.6%

Thus cost of debt=7.6%

Let new chain requires $100mn

Equity=65 mn

Debt=35mn

Proceed from equity=65*(1-floatation cost)=65*(1-0.12)=57.2mn

Proceed from Debt=35*(1-floatation cost)=35*(1-0.05)=57.2mn=33.25mn

New WACC=(E/(D+E))*New cost of equity+(D/(D+E))*Cost of debt

New WACC=(57.2/(57.2+33.25))*0.103+(33.25/(57.2+33.25))*0.076=9.31%

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