Question

You want to estimate the appropriate discount rate for a new project. For this, you find...

You want to estimate the appropriate discount rate for a new project. For this, you find that there is a comparable firm ABC being traded on financial markets with the following data: debt-equity ratio 1.00, and equity beta 1.5. The current T.Bill rate is 4percent and the market risk premium is 8 percent. Assume that the debt of firm ABC is risk-free. What is the appropriate discount rate for the project?
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Answer #1
Cost of debt
Cost of debt 4.00% Since debt is risk free
Tax rate 0%
After-tax cost of debt =4%*(1-0%)
After-tax cost of debt 4.00%
Cost of equity stock
Cost of equity= Risk free rate + beta * Market risk premium
Cost of equity= 4% + 1.5 * 8%
Cost of equity= 16.00%
Calculation of WACC
Cost Capital Weight Weighted cost
A B Weight C=Capital component/Total capital D=A*C
Debt 4.00% $      1.00 =1/2 50.00% 2.00%
Equity 16.00% $      1.00 =1/2 50.00% 8.00%
Total capital $      2.00 Total WACC 10.00%
So the discount rate should be used as 10%.
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