Question

(20 ml) 2. Best Food Ltd is a processing firm which is 100% equity financed. The company's board of directors are considering diversifying their operations by entering into the consumer electronics industry. Additional information: 1. The current equity beta is 1.2 and 1.6 for Best Food Ltd and electronic firms respectively. 2. The gearing in the electronic industry averages 30% debt and 70% equity 3. Return on market is 25% 4. The risk free rate is 10% Assume a corporation tax rate of 30%. U . 10 norte

determine suitable discount rate for the new investment if directors were to finance the new project as follows;
1) 30% debt and 70%equity
2)Entirely by equity
3)40% debt and 60% equity

Answer 1

Cost of Debt is not provided in question thus, we assumed before tax cost of debt is risk free rate i.e 10%

Before tax cost of debt = 10%

Tax rate = 30%

Post tax cost of debt (kd) = 10%*(1-30%) = 7% = 0.07

Equity Beta for electronic firms = 1.6

Market return = 25%

Risk free rate = 10%

Cost of equity(ke) = 10% + 1.6*(25%-10%) = 34% = 0.34

1) If new investment financed by 30% debt and 70% equity:

$\small \textup{Suitable Discount rate = 0.3*0.07+0.7*0.34 }$

$\bg_green \large \textup{Suitable Discount rate = 25.90\%}$

2) If new investment financed entirely by equity:

$\bg_green \large \textup{Suitable Discount rate = 34.00\%}$

3) If new investment financed by 40% debt and 60% equity:

$\small \textup{Suitable Discount rate = 0.4*0.07+0.6*0.34 }$

$\bg_green \large \textup{Suitable Discount rate = 23.20\% }$

Hope this will help, please do comment if you need any further explanation. Your feedback would be highly appreciated.