Module $6$ Chapter $9$ CASE X $($WACC$)$: WACC for a New Project

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 $1\mathrm{.}17,$ the new chain is expected to have a beta of $0\mathrm{.}8.$

LilyMac currently has $500,000$ shares of common stock outstanding, which are selling

for $$63\mathrm{.}72$ per share, and a $$10$ million dollar bond issue, selling at $104$ percent of par.

The expected market risk premium is $6$ percent, and the current risk$-$free rate is $5\mathrm{.}5\%.$

The bonds pay an $8$ percent semiannual coupon and mature in $20$ years.

LilyMac's next expected dividend is $$4\mathrm{.}00$ per share, and future dividends are expected

to grow at $4\%$ per year.

The current operations of the firm produce EBIT of $$18$ million per year, and the chain's

operations are expected to add only $$25$ million per year to that. The new chain will be

funded with $65\%$ percent equity and $35\%$ debt, and estimated flotation costs are

expected to be $12$ percent and $5$ percent, respectively.

The current EBIT of $$18$ million per year puts the firm in the $38\%$ tax bracket, so

the additional EBIT generated by the project will be taxed at an average marginal

tax rate of:

$\frac{\text{\$}333,333}{\text{\$}25,000,000}38\%+\frac{(\text{\$}25,000,000-\text{\$}333,333)}{\text{\$}25,000,000}35\%=35\mathrm{.}04\%$

Therefore, Please use the $35\mathrm{.}04\%$ Tax in your calculations of the after tax cost of debt.

What should be the WACC for the new chain of coffee shops?