Question

DEF Inc., a conglomerate with multiple business divisions, is evaluating a project in its transportation division. The transportation industry has an average debt-to-total-assets ratio of 30% and an average levered beta of 1.28. DEF will finance this project with a debt-to-total-assets ratio of 40%. Both DEF and the transportation industry have a tax rate of 40%. The risk-free rate is 5% and the expected market rate of return is 10%. What is the required rate of return for this project?

Select one:

a. 12.1%

b. 9.1%

c. 10.1%

d. 11.1%

Answer #1

debt-to-total-assets ratio for a transport industry = 30%

So, Debt equity ratio of the industry = 30%/(1-30%) = 42.86%

tax rate T = 40%

Levered beta of industry = 1.28

So unlevered beta using formula

Bu = BL/(1 + (D/E)*(1-T)) = 1.28/(1 + 0.4286*(1-0.4)) = 1.018

DEF Inc.'s Debt-to-total-assets ratio = 40%

So, Debt equity ratio = 40%/(1-40%) = 66.67%

Using unlevered beta of industry, levered beta of the firm is

BL = Bu*(1 + (D/E)*(1-T)) = 1.018*(1 + 0.6667*(1-0.4)) = 1.425

Risk free rate Rf = 5%

Expected return on market Rm = 10%

using CAPM model, expected rate of return on DEF Inc's project is

E(r) = Rf + Beta*(Rm-Rf) = 5 + 1.425*(10-5) = 12.1%

Option A is correct.

Problem #2
Assume that a conglomerate wishes to consider
establishing a new division. Those companies within industry in
which the proposed division will be part, reflect an average 'beta'
of 1.20 and a Market Value based Debt/Asset ratio 0.40. The
conglomerate is anticipating a Market Value based Debt/Asset ratio
for their new division of 0.67. With a prevailing risk-free rate of
6%, an historic excess market return of 7.50%, and a corporate tax
of 21%, calculate the weighted after-tax cost...

You are estimating a fundamental beta for a company with two
divisions. Division A has LTM sales of $2,611.5 million and
division B has LTM sales of $1,015.5 million. The average
cash-adjusted unlevered beta for firms in a sector comparable to
division A is 1.24 and the average cash-adjusted unlevered beta for
firms in a sector comparable to division B is 0.97. The average
enterprise value to sales multiple for firms in a sector comparable
to division A is 2.84x...

Far West inc. manufactures telecommunication equipment and
communication software. The equipment division is asking the
finance department of Far West for an estimate of its cost of
capital. Far West can borrow long term at 7%: its corporate tax
rate is 1.05. The rate of interest on government bonds is currently
5.2%, and the market risk premium is 5%. The finance department has
identified three single business companies with activities that are
similar to those of the equipment division of...

[Q18-Q23] You are evaluating a 1-year project that is in line
with the firm’s existing business. Specifically, this new project
requires an investment of $1,200 in free cash flow today, but will
generate $1,600 one year from today. The project will be partially
financed with a 1-year maturity debt whose face value is $200 and
interest rate is 10%.
Suppose that you estimated the cost of equity as 20%, based on
the firm’s stock data. However, you were not able...

1. You are evaluating a 1-year project that is in line with the
firm’s existing business. Specifically, this new project requires
an investment of $1,200 in free cash flow today, but will generate
$1,600 one year from today. The project will be partially financed
with a 1-year maturity debt whose face value is $200 and interest
rate is 10%. Suppose that you estimated the cost of equity as 20%,
based on the firm’s stock data. However, you were not able...

Blue Angel, Inc., a private firm in the holiday gift industry,
is considering a new project. The company currently has a target
debt–equity ratio of .40, but the industry target debt–equity ratio
is .35. The industry average beta is 1.20. The market risk premium
is 8 percent, and the risk-free rate is 6 percent. Assume all
companies in this industry can issue debt at the risk-free rate.
The corporate tax rate is 40 percent. The project requires an
initial outlay...

Blue Angel, Inc., a private firm in the holiday gift industry,
is considering a new project. The company currently has a target
debt–equity ratio of .45, but the industry target debt–equity ratio
is .40. The industry average beta is 1.30. The market risk premium
is 7 percent, and the risk-free rate is 5 percent. Assume all
companies in this industry can issue debt at the risk-free rate.
The corporate tax rate is 34 percent. The project requires an
initial outlay...

Blue Angel, Inc., a private firm in the holiday gift industry,
is considering a new project. The company currently has a target
debt-equity ratio of .40, but the industry target debt-equity ratio
is .45. The industry average beta is 1.20. The market risk premium
is 6.8 percent and the risk-free rate is 4.4 percent. Assume all
companies in this industry can issue debt at the risk-free rate.
The corporate tax rate is 22 percent. The project requires an
initial outlay...

Hula Enterprises is considering a new project to produce solar
water heaters. The finance manager wishes to find an appropriate
risk adjusted discount rate for the project. The (equity) beta of
Hot Water, a firm currently producing solar water heaters, is 1.
Hot Water has a debt to total value ratio of 0.3. The expected
return on the market is 0.1, and the riskfree rate is 0.03. Suppose
the corporate tax rate is 34 percent. Assume that debt is riskless...

National Electric Company (NEC) is considering a $45.2 million
project in its power systems division. Tom Edison, the company’s
chief financial officer, has evaluated the project and determined
that the project’s unlevered cash flows will be $3.3 million per
year in perpetuity. Mr. Edison has devised two possibilities for
raising the initial investment: Issuing 10-year bonds or issuing
common stock. The company’s pretax cost of debt is 8.9 percent, and
its cost of equity is 12.8 percent. The company’s target...

ADVERTISEMENT

Get Answers For Free

Most questions answered within 1 hours.

ADVERTISEMENT

asked 3 minutes ago

asked 3 minutes ago

asked 5 minutes ago

asked 6 minutes ago

asked 6 minutes ago

asked 6 minutes ago

asked 9 minutes ago

asked 9 minutes ago

asked 9 minutes ago

asked 10 minutes ago

asked 11 minutes ago

asked 17 minutes ago