Cost of Capital, Leverage and Capital Structure

magine that you own a company, Optimus, Inc., which is funded with 40% debt and 60% common stock; there is no preferred stock in the capital structure. The debt has an after-tax cost of 4%. You have studied the Electrobicycle project, and you believe that the auto company who has done the research and development (R&D) has made a crucial mistake. You believe that after the first 5 years, there will be worldwide expansion opportunities and many more years of revenues and earnings from selling Electrobicycles. Thus, you would not shut down the project in Year 5. Instead, you believe you will be able to sell the Electrobicycle business in Year 5 to a multinational company that will continue to produce the products and sell them internationally for many years into the future. You believe the sale of the Electrobicycle business in Year 5 will be for at least $15.0 million. Thus, you believe the value of the Electrobicycle project is significantly higher than the auto company realizes.

For the initial post,

• Calculate Optimus required rate of return on equity using the capital asset pricing model (CAPM). For the CAPM, use the following assumptions:
• Use a risk-free rate of 4.0%.
• Use 6.0% as the market risk premium.
• For the beta, use 1.10 
• Calculate the WACC for Optimus. As a reminder, Optimus is funded with 40% debt and 60% common stock; there is no preferred stock in the capital structure. The debt has an after-tax cost of 4%.
  • Use the Optimus required rate of return on equity that you calculated using the CAPM.
• Explain why it is appropriate for Optimus to value the Electrobicycle project using its WACC. Compare using the WACC to using solely the cost of equity in valuing the Electrobicycle project.

• Watch the following video attached:

• After watching the video, answer the following questions in your post:

  • Did Alex Clark initially fund the business with equity or debt?
  • Initially, Clarks chocolate business is very small. Compared to publicly traded companies, would Clarks required rate of return on equity be higher or lower than the average required rate of return on equity for small cap companies of 15%? Explain your answer.
  • After the business was established, Clark talked about buying a building to expand. This is a good example of an investment project that a business must evaluate. Would the required rate of return for Clarks building purchase be higher or lower than the overall chocolate companys required rate of return? Explain your answer.
  • Should Clark use some bank debt to finance all or a portion of the building purchase?
    • Justify your answer by explaining how the weighted average cost of capital for the company would change if Clark uses bank debt to finance all or a portion of the building purchase.
  • What is the primary risk that Clark faces if she uses debt to finance the entire building purchase? For purposes of this discussion, assume that the debt would then comprise 95% of the companys capital structure.