Question

JT Corp.'s uses CAPM for the investment appraisal and is financed by debt and equity only. JT estimates its WACC at 12% and its capital structure includes 75% debt and 25% equity. JT pays tax at 20% and its pre-tax cost of debt amounts to 12.5%. The risk-free rate is currently 6% and the market risk premium equals 8%. Please calculate the beta of JT and comment if you would add JT to your portfolio as a defensive stock .

Answer 1

Solution :-

WACC = 12%

Weight of Debt = 75%

Weight of Equity = 25%

Cost of Debt = 12.5% * ( 1 - 0.20 ) = $10.00%

Cost of Equity ( ke ) = ??

Now WACC = ( Ke * We ) + ( Kd * Wd )

12% = ( Ke * 0.25 ) + ( 10% * 0.75 )

Ke = 4.5% / 0.25

Ke = 18%

Now As per CAPM

Ke = Rf + Beta * ( Rm - Rf )

18% = 6% + Beta * 8%

Beta = 12% / 8% = 1.50

Therefore Beta of JT = 1.50

And if we want add JT in the portfolio then the risk of the project is increase and as risk increase the projects gives high return

If there is any doubt please ask in comments

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