Question

A firm is considering diversifying and investing in a line of business in an industry in which the firm does not currently operate. In doing some research, you determine the new industry has an average equity beta of 1.09, an average debt-to-equity ratio of 15% ,and an average tax rate of 40%. Your firm has a debt ratio of 20%, but the same average tax rate of 40%. Assume that debt betas in the firm and new industry are zero.

a.	What beta would you use in the CAPM model to determine the appropriate cost of equity for the evaluation of the project?
b.	Why would this be an appropriate beta?
c.	The expected return on the market portfolio is 9% while the risk-free rate of interest is 4%. What would be the CAPM derived cost of equity? Is this the appropriate discount rate for the project’s cash flows?

Answer 1

(b)This is appropriate beta because we can not directly use the industry equity beta for our project because our capital structure is different from industry capital structure .Therefore we have first calculated unlevered or asset beta of industry and then used our capital structure to calculate equity beta for new business .Hence ,the beta which we have calculated is appropriate beta

(C) CAPM derived cost of equity = Risk free return + (Market return -risk free return ) *beta

=4+(9-4)*1.15=9.75%

This is not the appropriate discount rate for discounting cash flows because weighted average cost of capital is taken as discount rate for discounting cash flows which will be equal to weighted average of cost of debt and equity. When debt is also used for financing new business then we cannot use only cost of equity for discounting cash flows .