Barfly Inc. manufactures and markets a line of non-alcoholicmixers sold to restaurants and bars. Barfly’s Creative Bartenderhas recently experimented with making alcoholic versions with theintention of bottling and marketing these directly to the publicthrough appropriate retail outlets. Prior spending on R&D was$1.5 million and Barfly anticipates spending half of that againduring the first year of the project to conclude R&D (for totalR&D of $2.25 million). The cost of building the manufacturingline is estimated at $1,175,000. Marketing projects revenues fromthe new product line will be 800,000 units in the first year,growth in years 2 and 3 at 15%, growth in year 4 at 10%, and 5% foryear 5. While Barfly anticipates the product will have a longerlife than 5 years, their initial projections are for a 5 year timehorizon, fully depreciating the cost of plant and equipment overthat time on a straight-line basis. Revenue per unit is projectedto be $2.50 in the first year, with prices rising by 3% per yearthereafter. COGS are projected to be 68% of revenues, SG&A 7%of revenues, and the company’s marginal tax rate is 32%. Networking capital required for the project is expected to be 2% ofrevenues annually once the project is fully online in year 1.Barfly’s balance sheet includes $3,000,000 in total capital, ofwhich $980,000 is debt. The market yield to maturity on debt is3.75%, the risk free rate on a 5-year Treasury is 3%, and themarket risk premium is 6.5%. The company’s beta is 1.3 and the CFOuses the CAPM to estimate cost of equity.

Management has been studying the company’s capital structure andis considering using a small secondary offering of stock to paydown debt. The following data is used to determine the cost of debtunder varying capital structures.

Debt ratio	Spread to Treasuries	Yield on Debt
0% - <10%	0.00%	3.000%
10% - < 20%	0.15%	3.150%
20% - < 30%	0.30%	3.300%
30% - < 40%	0.50%	3.500%
40% - < 50%	0.75%	3.750%
50% - < 60%	1.05%	4.050%
60% - < 70%	1.35%	4.350%
70% - < 80%	1.90%	4.900%
80% - < 90%	2.50%	5.500%
90% - < 100%	3.10%	6.100%
100% - < 110%	3.80%	6.800%
110% - < 120%	4.70%	7.700%
120% - < 130%	6.00%	9.000%
130% - < 140%	7.20%	10.200%
140% - < 150%	9.00%	12.000%
150% - < 160%	11.00%	14.000%

1. If Barfly issues $180,000 in new equity and uses the proceedsto repurchase (and defease*) existing debt, what would theresulting weighted average cost of capital be?

2)Should management move towards this capital structure? Why orwhy not?