Imagine that you own a company, Optimus, Inc., which is funded with 40% debt and 60% common stock; there is no preferred stock in the capital structure. The debt has an after-tax cost of 4%. You have studied the Electro-bicycle project, and you believe that the auto company who has done the research and development (R&D) has made a crucial mistake. You believe that after the first 5 years, there will be worldwide expansion opportunities and many more years of revenues and earnings from selling Electro-bicycles. Thus, you would not shut down the project in Year 5. Instead, you believe you will be able to sell the Electro-bicycle business in Year 5 to a multinational company that will continue to produce the products and sell them internationally for many years into the future. You believe the sale of the Electro-bicycle business in Year 5 will be for at least $15.0 million. Thus, you believe the value of the Electro-bicycle project is significantly higher than the auto company realizes.

• Calculate Optimus required rate of return on equity using the capital asset pricing model (CAPM). For the CAPM, use the following assumptions:
  • Use a risk-free rate of 4.0%.
  • Use 6.0% as the market risk premium.
  • For the beta, use 0.30.

• Calculate the WACC for Optimus. As a reminder, Optimus is funded with 40% debt and 60% common stock; there is no preferred stock in the capital structure. The debt has an after-tax cost of 4%.
  • Use the Optimus required rate of return on equity that you calculated using the CAPM.
• Explain why it is appropriate for Optimus to value the Electro-bicycle project using its WACC. Compare using the WACC to using solely the cost of equity in valuing the Electro-bicycle project.