Question

8. An all-equity firm is considering financing its next investment project with a combination of equity and debt. The asset beta for the firm as a whole is 1.2 (recall that this is the same as the equity beta for an all-equity firm, but not the same as the equity beta for a “levered” firm). Assume the average rate of return on the market is 6% and the risk-free rate is 1%. The cost of debt for the company is 3% and it faces a corporate tax rate of 20%. The investment will generate net cash flow of $1,000 per year in perpetuity starting one year from today. Assume that the $1,000 per year in cash flow is net of the investing activities in the project, so when calculating the NPV you don’t need to subtract the investment cost.

a. Find the NPV of the project if it is financed entirely with equity.

b. Find the NPV of the project if it is financed with 60% equity and 40% debt. In this case, the equity beta is not identical to the asset beta (due to the leverage) and so you will need to calculate the equity beta before you can determine the firm’s cost of equity capital. You can assume the beta on debt is zero.

Answer 1