Activity 1 An all-equity company operates in an industry where its beta factor is 0

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Activity 1

An all-equity company operates in an industry where its beta factor is 0.90. It is considering whether

to invest in a completely different industry. In this other industry, the average debt/equity ratio is

40% and the average beta factor is 1.25. The risk-free rate of return is 4% and the average market

return is 7%. If the company does invest in this other industry, it will remain all-equity financed. The

rate of taxation is 30%. Assume that debt is risk-free. Required

What cost of capital should be used to evaluate the proposed investment?

 

Activity 2

A company is planning to invest in a project in a new industry where it has not invested before. The

asset beta for the project has been estimated as 1.35. The project will be financed two-thirds by

equity capital and one-third by debt capital. The rate of taxation on company profits is 30%. Assume

that the debt capital is risk-free. The risk-free rate of return is 3% and the market return is 8%. What cost of equity should be used to

calculate the marginal cost of capital for this project?

 

Activity 3

A company is considering whether to invest in a new capital project where the business risk will be

significantly different from its normal business operations. The company is financed 80% by equity

capital and 20% by debt capital. It has identified three companies in the same industry as the

proposed capital investment and has obtained the following information about them:

(1) Company 1 has an equity beta of 1.05 and is financed 30% by debt capital and 70% by equity. (2) Company 2 has an equity beta of 1.24 and is financed 50% by debt capital and 50% by equity. (3) Company 3 has an equity beta of 1.15 and is financed 40% by debt capital and 60% by equity. The risk-free rate of return is 5% and the market rate of return is 8%. Tax on company profits is at

the rate of 30%. Assume that the debt capital in each company is risk-free. Required:

Calculate a project-specific discount rate for the project, assuming that this is:

(a) the project-specific cost of equity for the project, or

(b) the weighted average of the project-specific equity cost and the company's cost of debt capital.