ABC is an American cooky and cake manufacturer and the largest retail supplier of cookies globally. ABC is known for its great quality but has not tailored its products to the entire spectrum of the market. In particular, so far it has not produced gluten-free cookies or cakes but is considering to manufacture these as well. ABC has most of the equipment to produce gluten-free products, however, it needs to install a couple of new mixers which requires an investment of $2,800,000.

ABC has hired a firm of consultants to assess whether entering the gluten-free niche market is interesting and to provide estimates of the impact of the purchase of these mixers on the revenues and costs of the firm. The consultants expect that upon entering the gluten-free market, revenues will increase with $640,000 a year for the upcoming years, while the operating costs will increase with $40,000 because specialized employees need to operate the new machines. ABC received a bill for this advice totalling $24,000 that has to be paid in separate instalments of $4,000 yearly over the next 6 years.

The new mixers will be depreciated on a straight-line basis over their life of 6 years and will then be sold. Management expects that the fiscal residual (salvage) value of the mixers will be $1,000,000 after 6 years, whereas the re-sale (market) price of the machine is estimated at $600,000 after 6 years. ABC faces a corporate tax rate of 40%. You can assume the Modigliani-Miller theorem holds, so there are no frictions or market imperfections, except for the corporate tax.

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The risk characteristics of the above investment opportunity differ from those of the average assets in place of ABC. You decide to base the WACC on information of two competitors, Aldos Lebkuchen Inc. (ALI) and Biscuit Excellence Ltd. (BEL), that are active in the niche market for gluten-free products too. Both firms face a corporate tax rate of 40% as well. The management of ABC, ALI and BEL apply a continuously adjusted (dynamic) debt policy to maintain a fixed target debt-to-equity ratio. ABC will target a debt-to-equity ratio of 0.6. In the table below you can find the return on equity (rE), the target debt-to-equity ratio (D/E) and the fraction of gluten-free assets relative to total assets for the other two companies. You can assume that the debt of all companies (ABC, ALI, and BEL) is risk-free. Furthermore, the risk-free rate is 1% and you may assume the assumptions underlying the Capital Asset Pricing Model (CAPM) hold.

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Gluten-free Assets/Other Assets Firm TE D/E ALI 15% 0 0.25 BEL 18% 0.5 0.5 Question: Calculate the unlevered cost of capital of the gluten-free business. Gluten-free Assets/Other Assets Firm TE D/E ALI 15% 0 0.25 BEL 18% 0.5 0.5 Question: Calculate the unlevered cost of capital of the gluten-free business