In: Finance
Suppose the market cap of Tired Hands Brewery is $40 million and the market value of its debt is $10 million. Assume that the company's stock has a beta of 1.2 and its debt is risk free. The current T-bill rate is 5%, the expected market risk premium is 10%, and the tax rate is 40%. Tired Hands is deciding between two mutually exclusive projects. The company could either invest in an expansion project that involves setting up a brewery in Massachusetts or a diversification project that involves the manufacture and sale of potato chips. There are two comparable “pure-play” firms that are solely engaged in the manufacture of potato chips: i) Baked Chip Co, which has no debt in its capital structure and has an equity beta of 0.9 and ii) Fried Chip Co, which has a debt to firm-value ratio of 0.1, an equity beta of 0.92, and a debt beta of 0.2. What discount rate should Tired Hands use when deciding whether or not to invest in the potato chip project? Assume debt interest payments are tax deductible.