Question
A firm is considering diversifying and investing in a line of business in an industry in which the firm does not currently operate. In doing
A firm is considering diversifying and investing in a line of business in an industry in which the firm does not currently operate. In doing some research, you determine the new industry has an average equity beta of 1.09, an average debt-to-equity ratio of 15% ,and an average tax rate of 40%. Your firm has a debt ratio of 20%, but the same average tax rate of 40%. Assume that debt betas in the firm and new industry are zero.
a. | What beta would you use in the CAPM model to determine the appropriate cost of equity for the evaluation of the project? |
b. | Why would this be an appropriate beta? |
c. | The expected return on the market portfolio is 9% while the risk-free rate of interest is 4%. What would be the CAPM derived cost of equity? Is this the appropriate discount rate for the projects cash flows? |
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