Question

Piedmont Hotels is an all-equity company. Its stock has a beta of .83. The market risk premium is 7.0 percent and the risk-free rate is 4.4 percent. The company is considering a project that it considers riskier than its current operations so it wants to apply an adjustment of 1.8 percent to the project's discount rate. What should the firm set as the required rate of return for the project? 8.41% 10.21% 12.01% 6.56% 8.36%

Answer 1

The formula for calculating the WACC is :

WACC= Kd (1-t)*(D/(D+E) + Ke*(E/(D+E)

Where,

WACC= Weighted average cost of capital or reuired rate of return.

Kd= Cost of debt

t = Tax rate

d= Market value of debt

E= Market value of equity

Since this is all equity firm, the required rate of return is the cost of equity, which is calculated as:

Ke = Risk free rate + Beta*Market risk premium

= 0.044 + 0.83*0.07

= 0.1021 or 10.21%

However, since the company is considering the project which is more riskier than the current operation of the company, we need to apply the adjustment factor (given as 1.8%) to get a project specific required rate of return

Hence, Ke = 10.21% + 1.8% = 12.01%

This is the rate the company should us to discount the projects cashflows in order to get its net present value or NPV.

If Instead the company did not adjust the discount rate then it will end up in overvaluing the project.