Question

In financial analysis, it is important to select an appropriate discount rate. A project’s discount rate must be high to compensate investors for the project’s risk. The return that shareholders require from the company as a compensation for their investment risk is referred to as the cost of equity.

Consider this case:

The Mitata Co. is a 100% equity-financed company (no debt or preferred stock); hence, its WACC equals its cost of common equity. The Mitata Co.’s retained earnings will be sufficient to fund its capital budget in the foreseeable future. The company has a beta of 1.35, the risk-free rate is 4.5%, and the market return is 5.9%.

What is The Mitata Co.’s cost of equity?

19.08%

8.02%

1.95%

6.39%

The Mitata Co. is financed exclusively using equity funding and has a cost of equity of 13.05%. It is considering the following projects for investment next year:

Project	Required Investment	Expected Rate of Return
W	$5,250	10.60%
X	$6,375	13.65%
Y	$4,575	14.10%
Z	$3,675	13.10%

Each project has average risk, and The Mitata Co. accepts any project whose expected rate of return exceeds its cost of capital. How large should next year’s capital budget be?

$13,500

$14,625

$9,825

15,300

Answer 1

i) Computation of Cost of Equity

Cost of Equity = Risk Free Rate + Beta * (Market Return - Risk Free Rate)
= 4.5% + 1.35 (5.9% - 4.5%)
= 4.5% + 1.89%
= 6.39%

Ans : The Mitata Co's Cost of Equity is 6.39%.

ii) Mitata Co. will accept any project whose expected rate of return exceeds its Cost of Capital. It has cost of capital of 13.05%. Thus the projects it will accept will be Project X,Y and Z since they have expected rate of return more than cost of capital of Mitata Co.

Total Capital Required = $6375 + $4575 + $3675 = $14,625

Ans : The Capital budget of Mitata Co. should be $14,625 next year