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

Solution.

Calculation for WACC.

Cost of equity through CAPM model = 5.5% + 0.8 x 6%

= 10.3%

Cost Of debt = 16% annual ( Tax bracket not given, and flotation cost just reduce net procceds )

WACC = 12%

Due to flotation cost net procced is reduce by flotation rate.

Capital Weight Cost WACC Equity                           0.65 10.30%                 0.067 Debt                           0.35 16.00%                 0.056 Total                    0.12

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