You own a well-established energy drink company that sells 50M units per year at a price of $2.50 per unit. The variable cost of producing each unit is $1.00, and the annual fixed cost of operating the business is $50M. The business is all-equity and has an equity beta of 0.90. Assume a risk-free rate of 3 percent and a market risk premium of 6 percent. a) What is the present value of the first five net cash flows (total revenues minus total variable costs minus fixed costs) produced by this business? You are worried about regulation being passed in five years that would limit the amount of caffeine that can be contained in an energy drink. You forecast that you will only be able to sell 34M units per year in perpetuity starting at t-6 if this regulation is passed (the price, variable cost, and fixed cost would remain unchanged). If the regulation is not passed, you will continue selling 50M units per year in perpetuity. b) From the point of view of t=5, what is the present value of the perpetual future net cash flows if the regulation is passed? Would you exercise your real option to shut down the business and sell it for $80M if the regulation is passed? c) From the point of view of t=5, what is the present value of the perpetual future net cash flows if the regulation is not passed? Would you exercise your real option to shut down the business and sell it for $80M if the regulation is not passed? d) From the point of view of t=0, the probability of the regulation being passed at t=5 is 25 percent and the probability of the regulation not being passed at t-5 is 75 percent. What is the NPV of your business today, given that you have the real option to shut down the business and sell it for $80M at t=5?
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
You own a well-established energy drink company that sells 50M units per year at a price of $2.50 per unit. The variable cost of producing each unit is $1.00, and the annual fixed cost of operating the business is $50M. The business is all-equity and has an equity beta of 0.90. Assume a risk-free rate of 3 percent and a market risk premium of 6 percent.
a) What is the
b) From the point of view of t=5, what is the present value of the perpetual future net cash flows if the regulation is passed? Would you exercise your real option to shut down the business and sell it for $80M if the regulation is passed?
c) From the point of view of t=5, what is the present value of the perpetual future net cash flows if the regulation is not passed? Would you exercise your real option to shut down the business and sell it for $80M if the regulation is not passed? d) From the point of view of t=0, the probability of the regulation being passed at t=5 is 25 percent and the probability of the regulation not being passed at t-5 is 75 percent. What is the NPV of your business today, given that you have the real option to shut down the business and sell it for $80M at t=5?
Here,
| Particulars | Values |
| Equity beta | 0.90 |
| Risk-free rate | 3.00% |
| Market risk premium | 6.00% |
| Sales units | 50,000,000.00 |
| Price per unit | $2.50 |
| Variable cost per unit | $1.00 |
| Annual fixed cost | $50,000,000.00 |
| Part A. Present value of first five net cash flows | ? |
| Part B. Present value of the perpetual future net cash flows if the regulation is passed | ? |
| Part C. Present value of the perpetual future net cash flows if the regulation is not passed | ? |
| Part D. Net present value of all future cash flows at t=0 | ? |
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