The Market Outlet has a beta of 1.38 and a cost of equity of 14.945 percent. The risk-free rate of return is 4.25 percent. What discount rate should the firm assign to a new project that has a beta of 1.25?

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22 April, 23:38

The Market Outlet has a beta of 1.38 and a cost of equity of 14.945 percent. The risk-free rate of return is 4.25 percent. What discount rate should the firm assign to a new project that has a beta of 1.25?

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Marin Melendez · Answer 1

The discount rate assign to a new project with a Beta of 1.25 is 13.94%

Explanation:

The applicable formula is the Capital Asset Pricing Model formula of Miller and Modgliani quoted below:

Ke = Rf + (Market risk premium x Beta)

Currently Ke=14.945%

Beta = 1.38

Risk free rate of return (Rf) is 4.25%

Market risk premium is the unknown

14.945%=4.25% + (Market Risk Premium) * 1.38

14.945%-4.25%=Market Risk Premium*1.38

10.70% = Market Risk Premium*1.38

10.70%/1.38=Market Risk Premium

Market Risk Premium = 7.75%

However, the new project cost of equity has to be determined due to having a different Beta factor of 1.25 (a different risk appetite)

Using the above formula, we have

Ke=4.25% + (7.75% * 1.25)

Ke = 13.94%