Question

Q1. You are a senior manager at an automobile company. In an effort to offer a full menu of auto and gas products, your firm is considering an oil exploration project. The CEO has selected the manager of the company’s truck division to oversee the project, and has asked you to evaluate whether the company should proceed with the exploration or not.

To help you evaluate the project, your associate gives you the following information:

Company	Equity beta	D/(D+E)
General American Oil	1.6	0.05
Lousiana Land & Exploration	1.2	0.20
Mesa Petroleum	2.6	0.15
Murphy Oil	1.7	0.30
Natomas Oil	1.8	0.45
Oceanic Exploration	1.5	0.24
Superior Oil	1.3	0.13

1. Should you also ask the associate for similar information on car manufacturers? On truck manufacturers? On automobile companies? Why or why not?
2. Based on the information you have available, calculate an appropriate discount rate assuming for the project that risk free rate is 4%, the expected market return is 8%, and the corporate tax rate is 20%. Assume that the oil exploration project is 84% equity financed.(please show me the detail calculation and steps. )(50 points)

assume cost of debt (return on debt) = risk free rate.

Answer 1

a. As per the concept of Capital Budgeting, the financial viability and eventual selection of a prospective project should be done after considering the initial investment and the future cash-flows that it generates, in such a way, that it leads to positive Net Present Value (NPV). The NPV for a project depends not only on the initial investment and future cash-flows, but also on the discount rate used to discount the future cash-flows. The discount rate, in essence, would depend on the nature of the project, the choice of gearing (proportion of equity contribution and debt financing by the company), the risk perception of companies undertaking a similar line of business etc.

Thus, if you were to evaluate the feasibility of a project in the Oil Exploration industry, you would primarily need data regarding comparable companies in the same line of business in order to arrive at an appropriate Discount Rate. Hence, your associate wouldn't be required to collect similar information on other lines of business like car manufacturers, truck manufacturers or automobile companies, as the nature of operations, business risk and financial risk involved in these businesses wouldn't be comparable to the subject business being discussed.

b. In order to arrive at a discount rate basis the proposed capital structure (84% equity and 16% debt which leads to D/E of 0.19), we would need to arrive at the cost of equity first, as the cost of debt is already assumed to be the risk-free rate i.e. 4%.

The cost of equity using the Capital Asset Pricing Model is,

Re = Rf + Beta*(Rm-Rf)

where,

Re = Cost of Equity

Rf = Risk free rate

BL = Levered Equity Beta for the company

Rm = Expected market return

In order to calculate the Levered Equity Beta for a private company, we need to follow these four steps:

1. Calculate the average equity beta of the comparable peers in order to arrive at the average industry levered beta

2. Calculate the average debt-to-equity ratio of the comparable peers, which will be then used to un-lever the above mentioned average industry levered beta

3. Arrive at the average industry un-levered beta using the following formula:

BU = BL/(1 + (1-t)*(D/E) )

where

BU = Unlevered Beta

BL = Levered Beta (the average equity beta of the comparable peers)

t = Corporate tax-rate

D/E = Average debt-to-equity ratio

4. In the last step, we need to re-lever the un-levered beta according to the proposed capital structure using the following formula:

BL = BU * (1 + (1-t)*(D/E) )

Step 1: Simple Average of equity beta from the table of comparable peers = BL = 1.67

Step 2: Simple Average of Debt-to-Equity ratio from the table of comparable peers = D/E = 0.22

Step 3: BU = 1.67 / (1 + (1 - 20%)*(0.22) )

= 1.67 / 1.176

BU = 1.42

Step 4: BL = 1.42 * (1 + (1 - 20%) * (0.19) )

= 1.42 * 1.152

BL = 1.636

Using the Levered Beta for the firm arrived above,

Cost of Equity = Re = 4% + (1.636)*(8%-4%)

Re = 4% + 6.54%

Re = 10.54%

Using the Weighted Average Cost of Capital formula we can arrive at the discount rate as,

WACC = (E/(D+E)) * Re + (D/(D+E)) * Rd * (1-t)

where,

E/(D+E) = Proportion of equity capital = 84%

D/(D+E) = Proportion of debt capital = 16%

Re = Cost of Equity = 10.54%

Rd = Cost of Debt = 4%

t = Corporate tax rate = 20%

Thus, WACC = (0.84)*(10.54%) + (0.16)*(4%)*(1-20%)

WACC = 8.85% + 0.51% = 9.36%

Thus the appropriate discount rate for the project is 9.36%.