Question

Use the following information to calculate the cost of capital for LOL Plc, on the assumption that investors can remove all unsystematic risk by diversification.

 The systematic risk of LOL Plc's equity is 0.80;

 The risk free rate is 10%;

 The expected rate of return on the market portfolio is 15%;

 The sources of funds used by LOL Plc and their respective market values are as follows:

Source of Funds	Market Value ($m)
Debt (par value $100)	1
Equity	3

 The interest rate on the debt is 11% paid annually. The debt, which is due to mature in eight years' time, has a current market price of $111.

 The company tax rate is 30%.

After tax cost of equity = 14%

WACC = 12.08%

Required: Under what assumptions is the cost of capital you have calculated for LOL Plc in (a) appropriate for a proposed project?

Answer 1

Under what assumptions is the cost of capital you have calculated for LOL Plc in (a) appropriate for a proposed project?

The cost of capital is appropriate for a proposed project under the following assumptions :

• The beta of the project is the same as the beta of the overall firm
• The riskiness of the project is the same as the risk of the overall firm
• The project is financed using the same capital structure weights as the overall firm
• The tax rate of the project is the same as that of the overall firm