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Capital Budgeting (Discount Rate Must be Estimated)
Previously assumed a discount rate.
Debt / Value Ratio
=
1/4
Thus,
Debt / Equity Ratio
=
1/3
Currently one firm in the industry:
Financing
Debt:
.40
Equity: .60
Beta:
1.5
iRate:
.12
Firm 2 Expects to borrow @ .10
Tc
=
.40
Mkt Risk premium
=
.085
Riskless iRate
=
.08
What is the appropriate discount rate for this venture for firm 2
Could use APV, FTE or WACC thus the appropriate discount rates are r0, rS, and rWACC
1. Determing Firm 1’s cost of equity Capital (rS)
(Use security market line (SML) of Chapter 10)
Rs
=
RF +
Beta
x
(RbarM 
RF)
=
.08 +
1.5
x
.085
=
.2075
NOTE:
RbarM = the expected return on the market portfolio
RF
= the riskfree rate
2. Determing Firm 1’s Hypothetical AllEquity Cost of Capital (r0)
rS
=
r0
+
B/S
(1 – Tc) (r0 – rB)
.2075
=
r0
+
.4/.6
(.6)
(r0  .12)
r0
=
.1825
At this pont … assume risk of their venture is about equal to the risk of firms in industry
Thus, hypothetical discount rate of Firm 1 if allequity financed = .1825.
NOTE: This would be used if APV approach since APV uses r0
3. Determine rS for FTE approach
rS
=
r0
+
B/S (1Tc)
x
(r0 – rB)
=
.1825
+
1/3 (.60)
x
(.1825  .10)
=
.199
Firm 1’s cost of equity capital (.199)
<
Firm
2’s
(.2075)
This occutrs b/c Firm 2 has a higher debt / equity
WWHHYY??
Note both firms are assumed to have the same business risk
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 Spring '10
 jaffe
 Debt

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