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A project manager is trying to ascertain a discounting rate for the project cash flows that...

A project manager is trying to ascertain a discounting rate for the project cash flows that carry the same risk as the core business of the firm. The manager has been told by the finance team at the firm that the current capital structure has a debt to value ratio of 0.3, however, they are targeting a ratio of 0.25 to get a better credit rating. The better credit rating would reduce the cost of debt to 7%. The current return on the firm’s equity is 15% and the current cost of debt is 8%. What is an appropriate discount rate for the project cash flows if the tax rate is 25%?

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Expert Solution

cost of unlevered equity=(15%+8%*0.3/0.7*(1-25%))/(1+0.3/0.7*(1-25%))=13.2973%

Target cost of equity=13.2973%+(13.2973%-7%)*0.25/0.75*(1-25%)=14.871622%

Discount rate=0.25*7%*(1-25%)+0.75*14.871622%=12.4662%

jeff jeffy answered 2 years ago
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