Bookscape is considering investing in an online book ordering and

information service, which will be staffed by two full-time employees. The following estimates relate
to the costs of starting the service and the subsequent revenues from it.
1. The initial investment needed to start the service, including the installation of additional phone
lines and computer equipment, will be $1 million. These investments are expected to have a life
of four years, at which point they will have no salvage value. The investments will be depreciated
straight line over the four-year life.
2. The revenues in the first year are expected to be $1.5 million, growing 20% in year 2, and 10% in
the two years following.
3. The salaries and other benefits for the employees are estimated to be $150,000 in year 1, and
grow 10% a year for the following three years.
4. The cost of the books is assumed to be 60% of the revenues in each of the four years.
5. The non-cash working capital, which includes the inventory of books needed for the service and
the accounts receivable (associated with selling books on credit), is expected to amount to 10%
of the revenues; the investments in working capital have to be made at the beginning of each
year. At the end of year four, the entire working capital is salvaged at book value.
6. The tax rate on income is expected to be 40%, which is also the marginal tax rate for Bookscape.
estimates relate

, and 10% in

service and

Bookscape.
Year 0 1 2 3
+ Earnings before interest and taxes (1 − t) 0 120,000 183,000 216,300
+ Depreciation and amortization 0 250,000 250,000 250,000
− Change in noncash working capital -150,000 -30,000 -18,000 -19,800
− (Capital expenditures − Disinvestments) -1,000,000 0 0 0
= Cash flow to firm -1,150,000 340,000 415,000 446,500

Year 0 1 2 3
Earnings before interest and taxes (1 − t) 0 120,000 183,000 216,300
Revenues 1,500,000 1,800,000 1,980,000
20% 10%
Book cost 900,000 1,080,000 1,188,000

Labor cost 150,000 165,000 181,500

10% 10%
Depreciation and amortization 250,000 250,000 250,000

Year 0 1 2 3
Change in noncash working capital 150,000 30,000 18,000 19,800
Noncash working capital 150,000 180,000 198,000 217,800

Year 0 1 2 3
Capital expenditures 1,000,000

we will use fcff to calculate the cost of capital shareholders + debt providers
but if it was fcfe it would be cost of equity only shareholders
 4
252,930
250,000
217,800
0
720,730

4
252,930
2,178,000
10%
1,306,800

199,650
10%
250,000

4
-217,800
0

4
we will use CAPM
risk-free rate ==> first go to treasury us --> https://home.treasury.gov/ --> data --> interest rates --> Daily Treasury Par
our bonds are for 4 years, so we will take the avg of 3 year and 4 year rates = 4.13+3.82/2 = 3.975/3.98
Risk premium ==> damodaran online --> data --> current data --> Implied Equity Risk Premiums for the US --> take the
unlevered total beta ==> damodaran online --> data --> current data --> Total Beta By Industry Sector --> in this exam
D/E (debt to equity ratio) (we have no debt, so d/e = 0) (and also means unlevered beta=levered beta here) --> every c

For undiversified owner

Risk-free rate (rate = %)
Risk premium (also %)
Unlevered total beta (not %) (unlevered because they don’t have debt --> levered if they have debt)
D/E (debt to equity ratio) because have 0% is not optimal
Tax rate (from the instruction)
Levered total beta (use the formula)
Cost of equity (riskfree + Beta * risk premium)

Default spread (margin)

Before-tax (nominal) cost of debt (risk free + default spread)
After-tax (effective) cost of debt (risk free + default spred *( 1-tax))
now we need to weight this averages-->
D/C --> debt/capital = d/e+d --> d/e = 8.16 so d/e*1/1+d/e = d/e/(1+d/e)
E/C ==> we have the same denominator as d/c and e+d=100% so just substract 100%-d/c
Cost of capital for the project (Bookscape) ==> cost of capital weighted average = cost of equity * weight + cost of d

here in the second table we will have to use normal common beta, not the levered beta--> because this investor only
For diversified owner
Risk-free rate
Risk premium
Unlevered beta
D/E
Tax rate
Levered beta
Cost of equity

Default spread (margin)

Before-tax (nominal) cost of debt
After-tax (effective) cost of debt

D/C
E/C
Cost of capital for the project (Bookscape)

for the test learn without the tables and complete in 30-60 seconds
the cost of capital = rate of return = hurdle rate
reasury.gov/ --> data --> interest rates --> Daily Treasury Par Yield Curve Rates -->
and 4 year rates = 4.13+3.82/2 = 3.975/3.98
ata --> Implied Equity Risk Premiums for the US --> take the most current year --> Implied ERP (FCFE) --> 4.24%
rrent data --> Total Beta By Industry Sector --> in this example, retail online --> make sure to take the total not the average --> 4.04
nd also means unlevered beta=levered beta here) --> every company should optimize their capital structure, and each sectore has its o

3.98%
4.24%
’t have debt --> levered if they have debt) 4.04
8.16%
40.00%
4.24
21.94%

1.30%
5.28%
3.17%

= d/e/(1+d/e) 7.54%
00% so just substract 100%-d/c 92.455621301775100%
pital weighted average = cost of equity * weight + cost of debt *weight 20.527%

on beta, not the levered beta--> because this investor only has market risk ---> instead of total unlevered data, it is only normal unleve

3.98%
4.24%
1.04
8.16%
40.00%
1.09
8.60%

1.30% 1.30%
5.28%
3.17%

7.5444%
92.46%
8.19%
RP (FCFE) --> 4.24%
o take the total not the average --> 4.04
apital structure, and each sectore has its own optimal --> this this case the d/e ratio would be the industry avg --> damodaran onine -->

tal unlevered data, it is only normal unlevered beta = 1.04

avg --> damodaran onine --> data --> current data --> Levered and Unlevered Betas by Industry --> retail online --> D/E Ratio (which is

dumb owner but high risk high return

low risk but wise guy so not a great return

ine --> D/E Ratio (which is the avg) --> 8.16%