Question

GBS Company has a debt-to-equity ratio (in market value terms) of 0.65. Its present cost of debt funds is 14 percent, and it has a marginal tax rate of 40 percent. GBS is eyeing the Discount card Business, a field that involves Vendors & market products and marketing services and is considerably different from its own line of business, so the company is looking for a benchmark or proxy company. The Global Max Company, whose stock is publicly traded, dealing only with marketing services. Global Max has a debt-to-equity ratio of 0.40, a beta of 1.19, and an effective tax rate of 0.40.

1. If GBS Company wishes to enter the automated bank teller business, what systematic risk (beta) is involved if it intends to employ the same amount of leverage in the new venture as it presently employs?

2. If the risk-free rate currently is 11 percent and the expected return on the market portfolio is 18 percent, what return should the company require for the project if it uses a CAPM approach?

Answer 1

Detailed solution is provided.