Question

Suppose the market cap of Tired Hands Brewery is $40 million and the market value of its debt is $10 million. Assume that the company's stock has a beta of 1.2 and its debt is risk free. The current T-bill rate is 5%, the expected market risk premium is 10%, and the tax rate is 40%. Tired Hands is deciding between two mutually exclusive projects. The company could either invest in an expansion project that involves setting up a brewery in Massachusetts or a diversification project that involves the manufacture and sale of potato chips. There are two comparable “pure-play” firms that are solely engaged in the manufacture of potato chips: i) Baked Chip Co, which has no debt in its capital structure and has an equity beta of 0.9 and ii) Fried Chip Co, which has a debt to firm-value ratio of 0.1, an equity beta of 0.92, and a debt beta of 0.2. What discount rate should Tired Hands use when deciding whether or not to invest in the potato chip project? Assume debt interest payments are tax deductible.

Answer 1

Tired Hands Brewery - Market Cap = $40 million , MV of Debt= $10 million

Company's stock beta = 1.2

Risk free rate of return = 5% (T bill rate)

Expected market risk preimum = 10%

Tax rate = 40%

Using CAPM model, we can determine the expected rate of return for Tired Hands Brewery.

According to CAPM Model,

Re = Rf + Beta*(Rm - Rf)

where, Re is expected rate of return; Rf is risk free rate of return, Rm is market rate of return; and (Rm - Rf) is market risk premium.

Re = 5 + 1.2*(10)

Re = 17%

As per CAPM model, The expected rate of return for Tired Hands Brewery is 17% and therefore it will consider the same rate as discount rate when deciding whether or not to invest in the potato chip project.

Note: Since the question has not asked to evaluate the two firms, we have not used their respective betas.