Question

In financial analysis, it is important to select an appropriate discount rate. A project's discount rate must be high to compensate investors for the project's risk. The return that shareholders require from the company as a compensation for their investment risk is referred to as the cost of equity. Consider this case: Weghorst Ltd is a 100% equity-financed company (no debt or preference shares); hence, its wACC equals its cost of equity. Weghorst Ltd's retained earnings will be sufficient to fund its capital budget in the foreseeable future. The company has a beta of 1.20, the risk-free rate is 4.0%, and the market return is 5.2% What is Weghorst Ltd's cost of equity? O 6.64% O 11.44% О 5.44% O 15.54% weghorst Ltd is financed exclusively using equity funding and has a cost of equity of 12.45%. It is considering the following projects for investment next year: Project Required Investment Expected Rate of Return $10,000 13.65% $15,000 12.10% $12,500 11.10% $17,500 14.60% Each project has average risk, and Weghorst Ltd accepts any project whose expected rate of return exceeds its cost of capital. How large should next year's capital budget be? O $45,000 O $27,500 $22,500

Answer 1

Weghorst Ltd's cost of equity is

$r_{e} = r_{f} + \beta *(r_{m} - r_{f})$

$r_{e} = 0.04 + 1.2 *(0.052 - 0.04)$

$r_{e} = 0.0544 = 5.44\%$

The expected rate of return of project W and Z is greater than the cost of equity of 12.45%. So, the next year's capital budget is 10,000 + 17,500 = $27,500

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