6. Adjusting for beta risk in capital budgeting - Debt and equity case The risk-

Question

6. Adjusting for beta risk in capital budgeting - Debt and equity case The risk-adjusted discount rate approach is widely used to evaluate risk for large projects, especially projects that have different risk profiles. These include projects that are financed with 100% equity and projects financed with both debt and equity. Consider the case of Jackson who works for a company called RADAT Inc. as a financial analyst. He is assigned to work on evaluating a new project. Before Jackson started to work on the analysis, he collected the following information from within the company · RADAT Inc. is financed with 65% equity and 35% debt financing, however, the new project is expected to be financed with 8S% equity and 15% debt. · The company has a market beta of 1.2. The current risk-free rate is 9%, and the market expects a return of 14.4%. The company pays a tax rate of 45%. The company's after-tax cost of debt is 99. · Jackson performed additional research regarding the project and has collected the following information from another company, CompDE Co.; which operates exclusively in the same line of business as the new project: CompDE Co. is financed with 80% equity and 20% debt. The company has a market beta of 1.0, and pays a tax rate of 4S%. · Jackson is expected to compute the required rate of return on the project. He's conducting the analysis in a step-by-step approach. In the following table, complete the calculations for each step of the analysis. Jackson's Analysis Value Step 1 Calculat e the unleveraged beta to be used for the new project (rounded to two decimal places)

Explanation / Answer

Un leveraged Beta of project= BL/{1+D/E(1-t)}

BU= 1.2/{1+35/65(1-0.45)= 1.2/1.29615= 0.92582 or 0.93

Beta of project is given by BL= BU{1+D/E(1-t)}

BL= 0.92582{1+15/85(1-0.45)}= 1.01568 or 1.02

Required rate of return for equity portion of the project is given by CAPM : Rf+ (Rm-Rf) × Beta of project

= 9+(14.4-9)1.01568= 14.48%

Cost of debt = 9×(1-0.45)= 4.95%

Cost of equity= 14.48%

WACC= 0.85×14.48+0.15×4.95= 13.05%

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