OldBooks, a book selling company with market assets of $100M, equity beta of 1.2 and D/E=1, is considering expanding into the internet business.

They have the following estimations regarding their potential on-line operations:

a) Next period cash flows of $2M growing in perpetuity at 4%

b) Required investment $15M

c) Equity beta of a comparable internet business with a D/E ratio of 1/3 is 2.

Risk-free rate rf = 4%, and the market premium is 8%. Both OldBooks' and the comparison firm's debt are risk free.

Assume that the tax rate is zero.

Question 1: According to these projections, should OldBooks expand into the internet business?

Question 2: Suppose that OldBooks decides to enter in the internet business. To do so, it issues securities to obtain the necessary capital for the investment (i.e., it does not use internally generated funds to invest). Find the value of the assets of the combined company after entering in the internet business. (Hint: Given that we are ignoring taxes, you can ignore the financing sources that OldBooks will use to make the required investment)

Question 3: Find the cost of capital (i.e., WACC) of OldBooks before entering in the internet business and after doing so. Does it change? Explain briefly.

Answer rating: 100% (QA)

Question 1 To determine whether OldBooks should expand into the internet business we need to compare the net present value NPV of the potential online ... View the full answer