Question

Food processing:

Yield corresponding to bond rating of BBB = 4.1%

After Tax Cost of Debt = Rd = (1 - Tax Rate) x Yield

= (1-0.37) x 4.1 = 2.583%

Average Beta= (0.55 + 0.6 + 0.7 + 0.75 + 0.5 + 0.55 + 0.65 + 0.6 + 0.7 + 0.8) / 10

= 0.64

Rf = 2.8

Rm = 6%

Cost of Equity = Re = Rf + Average Beta x Rm

= 2.8 + 0.64 x 6 = 6.64%

We = 0.8, Wd = 0.2

Risk Adjusted Cost of Capital = We x Re + Wd x Rd

= 0.8 x 6.64 + 0.2 x 2.583 = 5.8286 %

Instruments:

Yield corresponding to bond rating of BBB- = 4.6%

After Tax Cost of Debt =(1 - Tax Rate) x Yield corresponding to BBB bond = (1 - 0.37) x 4.6 = 2.898%

Average Beta of Comparable Company's

= (1.06 + 1.4 + 1.3 + 1.25 + 1.15 + 1.35 + 1.10 + 0.52) / 8

= 1.14125

Rf = 2.8 %,    Rm = 6%

Cost of Equity = Re = Rf + Average Beta x Rm = 2.8 + 1.14125 x 6 = 9.6475%

We = 0.8 and Wd = 0.2

Risk Adjusted Cost of Capital = We x Re + Wd x Rd

= 0.8 x 9.6475 + 0.2 x 2.898 = 8.2976 %

Give two reasons to support the use of one discount rate and two reasons to support different discount rates for each division.   

Answer 1

Discount Rate constitutes of an important characteristics and is an important distinction that would help the projects at time of need in deciding whether the project is suitable to invest or not.

Further, the discounting rate helps in determining the cash flows that could attribute in the future from a particular project or the investment that could be made to make the outlay of capital worth enough.

The similarities that can benefit a person by using the same discount rate are: -

· Helps in better comparison: - IF the project holds the similar belongings that can be attributed within the time then it is better to use the same rate for comparing the cash flow for the future that are discounted.

· Helps in determining the Net Present Value (NPV): - The firm which had arrived at the free cash flow using the discounted rate can help in calculating the NPV.

The reasons supporting that one could have different discounting rate are: -

· Varied Size of Project: - The project where the large revenue is attributed in comparison to the cost incurred needs to make profits. Thus every project and investment could vary in size. Therefore, their investment making decisions could not be same.

· Minimum Rate: - It states the universal minimum rate where risk premium could be added based upon the size and requirement of different projects.

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