Question

SAIPA Corp. is a publicly-traded company that specializes in car manufacturing. The company’s debt-to-equity ratio is 1/4 and it plans to maintain the same debt-to-equity ratio indefinitely. SAIPA’s cost of debt is 7%, and its equity beta is 1.5. The risk-free rate is 5%, the market risk premium is also 5%, and the corporate tax rate is 40%. Suppose that SAIPA is contemplating whether to start a new car production line. This project will be financed with 20% debt and 80% equity. The cost of debt for the new project is the same as the current SAIPA’s cost of debt.

The discount rate should SAIPA use to discount the cash flows from its new car production project = %

Answer 1

Discount rate should to use the discount the cash flows are at WACC.

Calculation of the WACC:-

WACC= Cost of debt * weight of debt * ( 1 -tax rate ) + Cost of equity * Weight of equity

Cost of equity under CAPM = Rf + Beta *market risk premium

= 5% + 1.5 * 5% = 5% + 7.5%

Cost of equity = 12.5%

cost of debt =7%

weight of debt = 0.20

weight of equity = 0.80

Tax rate =0.40

WACC= Cost of debt * weight of debt * ( 1 -tax rate ) + Cost of equity * Weight of equity

= 7% * 0.20 * (1 - 0.40) + 12.5% * 0.80

WACC = 10.84%

The appropriate discount rate = 10.84%

Note :- Here Let us assume cost of debt given in question is cost of debt before tax then discount rate is 10.84%

If, cost of debt given in question is after tax, then discount rate is 11.4%

WACC = 7% * 0.20 + 12.5% * 0.80 = 11.4%