Question

TaxiCorp is entirely financed with equity. Its risk premium is 14%. TaxiCorp calculates that a new project has a return of 16.5%. What other information is necessary to determine whether TaxiCorp should take the project? When should TaxiCorp accept the project?

Answer 1

TaxiCorp needs to calculate the cost of the Capital that will be employed for the project.

As TaxiCorp is entirely financed by equity, it essentially needs to find the cost of equity to be used in this project.

The cost of equity by CAPM method can be found by formula : Return on Equity= Risk Free Rate+Beta *Risk Premium.

In this case the Risk Premium is known , but Taxi Corp needs to get the Risk free rate of return and the beta of the project which will be equal to beta of projects in similar company with similar capital structure.

With getting these two information , the cost of equity for the project will be known.

If the cost of equity is lower than the project return rate of 16.5%, then the project can be accepted as it will give a net positive cash flow.

If the cost of equity comes out to be more than 16.5% , thyen the project should not be accepted as ther net cash flow from the project will be negative.