Question

Florida Corp. is calculating the appropriate rate for discounting cash flows on a project valued using the APV method. Florida’s target debt ratio (D/(D+E)) in market value terms is 50%, and the yield-to-maturity on its outstanding debt is 6%. A comparable firm has an equity β of 1.4 and a debt ratio (D/(D+E)) of 40%. Assume a risk-free rate of 5% and a market risk premium of 8%. Florida’s tax rate is 40%.
1. What discount rate should Florida use?
a. 7.66%
b. 11.02%
c. 11.72%
d. 18.44%

Answer 1

Answer:

option c 11.72%

Explanation:

We need to know the cost of equity which should be determinate with CAPM but we aren't given with the firm beta thus, we calcualte using the MM models and the similar beta of the other firm:

we multiply that beta by the capital structure of this similar firm

β of florida = (E/V x β) = 0.6 x 1.4 = 0.84

Now, that we got our firm beta we can solve for the CAPM:

$Ke= r_f + \beta (r_m-r_f)$

risk free = 0.05

premium market = (market rate - risk free) 0.08

beta(non diversifiable risk) = 0.84

$Ke= 0.05 + 0.84 (0.08)$

Ke 0.11720