Question

Buster's target debt-to-equity ratio is 0.65, its cost of equity is 13.7 percent, and its beta is 0.9. The after-tax cost of debt is 5.8 percent, the tax rate is 34 percent, and the risk-free rate is 2.3 percent. What discount rate should be assigned to a new project the firm is considering if the project's beta is estimated at 0.87?

Answer 1

As Per CAPM
Re=Rf+beta*(Rm-Rf)
Where Rf= Cost of equity
Rm= Expected Market rate of return
Rf= Risk free rate
13.7%=2.3%+0.9*(Rm-2.3%)
0.137=0.023+0.9Rm-0.0207
Rm=14.97%
So Expected Market Return rate =14.97%
Now D/E =0.65/1
New Project Beta =0.87
So cost of Equity for Project =Rf+beta(Rm-Rf)
Rep=2.3%+0.878(14.97%-2.3%)
Cost of equity for Project =13.32%
Post tax cost of ddebt Kd=5.8%
WACC for Project =Kep*E/(D+E) +Kd*D/(D+E)
WACC = 13.32%*1/1.65+5.8%*0.65/1.65
oe WACC =10.36%
So the required discount rate for the project is 10.36%	Ans