Question

The Weston Enchilada Company has a levered equity beta of 0.8. The company is thinking about getting into the Whataburger business. Currently, Weston Enchilada is financed with 50% long-term debt. The debt is risk free and pays 4% interest before taxes. A little research suggests that the Whataburger business is expected to yield 16% on after-tax total operating cash flows. For comparison, another Whataburger in town has an equity beta of 2.5 but has 20% debt in its capital structure. You can assume that the market return is 12%, marginal tax rates on everything are 35% and the new project would be financed with 50% debt. Find the WACC for the new Whataburger venture and decide what Weston Enchilada should do

Answer 1

To calculate the WACC for the new Whataburger venture, we need to consider the cost of equity and the cost of debt. Using the given data, we can calculate the WACC using the formulas for WACC and the cost of equity.

Step-by-step explanation:

To calculate the weighted average cost of capital (WACC) for the new Whataburger venture, we need to consider the cost of equity and the cost of debt. The formula for WACC is:

WACC = (E/V) * Re + (D/V) * Rd * (1 - tax rate)

Where E is the market value of equity, V is the total market value of the firm, Re is the cost of equity, D is the market value of debt, Rd is the cost of debt, and the tax rate is the corporate tax rate.

Since the Weston Enchilada Company has a levered equity beta of 0.8, we can calculate the cost of equity using the capital asset pricing model (CAPM):

Re = Rf + β * (Rm - Rf)

Using the data provided, we can substitute the values into the formulas to find the WACC.

Answer 2

Weston Enchilada should proceed with the Whataburger venture, as the calculated WACC is 11.3447%, which is lower than the expected return of 16% on the business.

The calculation of WACC (Weighted Average Cost of Capital) is needed here. Firstly, let's calculate the levered beta for the new venture. The equity beta for a similar Whataburger in town has 20% debt and a beta of 2.5. Converting this to an asset beta: 2.5 = asset beta/(1 + (1 - 0.35) * (0.20/0.80)). Solving this we get an asset beta of 1.33898.

Then you calculate the levered beta taking into account the 50% debt of Weston Enchilada: levered beta = 1.33898 *(1 + (1 - 0.35) * (0.50/0.50)) = 2.011187.

Next, calculate the cost of equity using CAPM. That would be: cost of equity = risk-free rate + levered beta * (market return - risk-free rate), which equals: 4% + 2.011187 * (12% - 4%) = 20.08949%.

The after-tax cost of debt would be: 4%(1-0.35) = 2.6%. Then, for WACC: WACC = (cost of equity * (equity / (equity + debt)) + (cost of debt * (debt / (debt + equity))). Assuming 50% of financing is from debt, then WACC = 0.2008949 * 0.5 + 0.026 * 0.5 = 0.113447. Or, 11.3447%.

Given that the expected return on the Whataburger business is 16% and our calculated WACC is 11.3447%, Weston Enchilada should proceed with this venture as the expected return is higher than the cost of capital.