Question

Alpha Industries uses the subjective approach to assign discount rates to projects. For a particular project, the subjective adjustment is +1.5 percent. The firm has a pretax cost of debt of 8.6 percent and a cost of equity of 13.7 percent. The debt-equity ratio is 0.65 and the tax rate is 35 percent. What discount rate should Alpha Industries use for this project?

Answer 1

Solution:

The formula for calculating the weighted average cost of capital is =

WACC = [ K_e * W_e ] + [ ( K_d * ( 1- t ) ) * W_d ]

K_e = Cost of equity ; W_e = Weight of equity ; K_d = Cost of debt ; t = Income tax rate ;

W_d = Weight of debt

As per the information available in the question we have

K_e = 13.7 % ; W_e = 1/ (1 + 0.65) = 1 / 1.65 = 0.6061 ;  

K_d = 8.6 %  ; t = 35 % = 0.35   ; W_d = 0.65 / ( 1 + 0.65 ) = 0.65/ 1.65 = 0.3939

Applying the above values in the formula we have

= [ 13.7 * 0.6061 ] + [ (8.6 * ( 1 – 0.35 ) ) * 0.3939 ]

= [ 13.7 * 0.6061 ] + [ ( 8.6 * 0.65 * 0.3939 ]

= [ 8.3036 + 2.2019   ]

= 10.5055

= 10.51 % ( when rounded off to two decimal places)

As per the information given in the question the subjective adjustment is +1.5 percent

Thus the discount rate for the project = 10.51 % + 1.5 % = 12.01 %

The discount rate that should be used by Alpha industries = 12.01 %