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 risk-free rate 2. Determing Firm 1’s Hypothetical All-Equity 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 all-equity financed = .1825. NOTE: This would be used if APV approach since APV uses r0 3. Determine rS for FTE approach rS = r0 + B/S (1-Tc) 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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