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Chapter 18

Capital structure and the choice of

discount rate

If an investment significantly changes the proportions of debt and equity
or the risk levels of the firm, or the finance is project-specific then the
existing WACC will no longer be an appropriate rate at which to
discount the investment cash flows.

When it is the risk that has changed (either by altering the gearing
levels or by moving into a different business area) the CAPM may be
used to find an up to date cost of equity to be used in a new calculation
of the WACC.

Question 4

The CAPM

Brixit Co is an all equity company with a beta of 1.4. It is appraising a one year
project with requires an outlay now of $5,000 and will return cash in one year
with a value ofT $6,000. The project has a beta of 1.2. Rf is 6% and Rm is
14%.

Calculate the firm’s current cost of equity capital, the minimum required return
of the project and determine whether the project is worthwhile.

Current cost of equity capital = 6 + 1.4 × (14 – 6) = 17.2%

Minimum return from the project = 6 + 1.2 × (14 – 6) = 15.6%

-1
PV of year 1 cash flow = cash flow × (1 + r)

-1
NPV of project at 15.6% = $(5,000) + $6,000 × 1.156
NPV = $190

With a positive NPV at the minimum required rate of return, the project is
worthwhile.

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