Question

Albright Properties Inc. (API) has three divisions:

Division	Beta	Proportion of Firm’s Assets
Property management	1.0		30%
Land resources	1.5		40
Financial services	—		30

The leveraged beta for API is 1.1. API has a consolidated capital structure consisting of 50 percent debt and 50 percent equity. The Financial Services Division’s capital structure is 80 percent debt and 20 percent equity. API is planning to finance new projects in that division with a capital structure of 90 percent debt and 10 percent equity. The risk-free rate is 5 percent, and the market risk premium is 8.9 percent. The pretax cost of debt to API is 20 percent. The tax rate is 40 percent. What discount rate should API apply to the cash flows from “new” projects in the Financial Services Division? Round your answer to one decimal place.

%

Answer 1

The beta of the API is 1.1 1*0.30 + 1.5 * 0.40 + Beta *0.30 = 1.1 beta * 0.30 = (1.1-(1*0.3 +1.5*0.4)) 0.20 beta = (0.2/0.3) 0.667 we neeed to find the levered beta at 90% debt and 10% equity unlevered beta 0.667/(1 +(1-0.4)*(0.8/0.2)) 0.196 levered beta 0.196*(1 + (1-0.4)*(0.9/0.1)) 1.25 The cost of equity (5 +1.25 * 8.9) 16.13 the discount rate that should be used is (0.9*20*(1-0.4) + 0.1*16.13) 12.41 The discount rate that should be used is 12.41%