Question

1. Cohn and Sitwell, Inc., is considering manufacturing special drill bits and other equipment for oil rigs. The proposed project is currently regarded as complementary to its other lines of business, and the company has certain expertise by virtue of its having a large mechanical engineering staff. Because of the large outlays required to get into the business, management is concerned that Cohn and Sitwell earn a proper return. Since the new venture is believed to be sufficiently different from the company’s existing operations, management feels that a required rate of return other than the company’s present one should be employed.

The financial manager’s staff has identified several companies (with capital structures similar to that of Cohn and Sitwell) engaged solely in the manufacture and sale of oil drilling equipment whose common stocks are publicly traded. Over the last five years, the median average beta for these companies has been 1.28. The staff believes that 18 percent is a reasonable estimate of the average return on stocks “in general” for the foreseeable future and that the risk-free rate will be around 12 percent. In financing projects, Cohn and Sitwell uses 40 percent debt and 60 percent equity. The after-tax cost of debt is 8 percent.

1. On the basis of this information, determine a required rate of return for the project, using the CAPM approach.
2. Is the figure obtained likely to be a realistic estimate of the required rate of return on the project?

Answer 1

Part (i)

Cost of equity, Ke = Risk free rate + Beta x Risk premium = 12% + 1.28 x (18% - 12%) = 19.68%

Hence, a required rate of return for the project = Proportion of debt x after tax cost of debt + Proportion of equity x Ke = 40% x 8% + 60% x 19.68% = 15.01%

Part (ii)

This is a subjective question. I believe it will not be a reasonable estimate because:

• Beta of the peer set companies have been used without taking into consideration their leverage. One should have ideally selected the median beta of those companies that have capital structure similar to our project.
• Secondly, the average return of stock "in general" has been used as a proxy of expected return from the market.

Because of these two anomalies, I believe this estimate is not a reasonable estimate.