Question

DEF Inc., a conglomerate with multiple business divisions, is evaluating a project in its transportation division....

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%

Homework Answers

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.

Know the answer?
Your Answer:

Post as a guest

Your Name:

What's your source?

Earn Coins

Coins can be redeemed for fabulous gifts.

Not the answer you're looking for?
Ask your own homework help question
Similar Questions
Problem #2 Assume that a conglomerate wishes to consider establishing a new division. Those companies within...
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...
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...
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....
[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....
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....
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...
Hula Enterprises is considering a new project to produce solar water heaters. The finance manager wishes...
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 1.4. Hot Water has a debt to total value ratio of 0.3. The expected return on the market is 0.11, and the riskfree rate is 0.06. Suppose the corporate tax rate is 38 percent. Assume that debt is riskless...
Blue Angel, Inc., a private firm in the holiday gift industry, is considering a new project....
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....
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...
8. An all-equity firm is considering financing its next investment project with a combination of equity...
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...
ADVERTISEMENT
Need Online Homework Help?

Get Answers For Free
Most questions answered within 1 hours.

Ask a Question
ADVERTISEMENT