Question

Burning Ltd. currently has the following financing outstanding.

Bond: 10,000 10-year zero coupon bonds with a quoted price of $500 (par value is $1000).

Common Stock: 50,000 shares of common stock. The company just paid $2 per share dividends to its investors. The dividends are expected to be constant in the future. The beta of the stock is 1.1.

The company is considering a new project which has the similar risk as the existing business. The market portfolio’s expected return is 10%, and the risk-free rate is 2%. The tax rate is 40%.

Required:

1. What is the cost of equity?
2. What is the cost of debt before tax?
3. c. What is the discount rate for the new project?

Answer 1

Solution:-

A. To Calculate Cost of Equity-

As per Capital Asset Pricing Model,

Cost of Equity = Risk Free Return + Beta * (Market Return - Risk Free Return)

Cost of Equity = 2% + 1.10 * (10% - 2%)

Cost of Equity =10.80%

Market Price of share = $2 / 10.80% = $18.52

B. To Calculate Cost of Debt-

Cost of Debt Before tax = 7.18%

Cost of Debt after tax = 7.18% (1 - 0.40)

Cost of Debt after tax = 4.308%

C. Discount Rate for new project-

WACC = WACC =

WACC =

WACC = 0.016875 + 0.0363

WACC = 5.32%

Discount Rate for new project is 5.32%

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