En financial analysis, it is important to select an appropriate discount rate. A
ID: 2614170 • Letter: E
Question
En financial analysis, it is important to select an appropriate discount rate. A project's discourt rate must be high to compensate investors for the project's risk. The return that shareholders require from the company as a compensation for their investment risk is referred to as the cost of equity Consider this case Hack wellington Co is a 100% equity-financed company (no debt or preferred stock); hence, its wACC capital budget in the foreseeable future. The company has a beta of 1.35, the risk-free rate is 4.5%. and the market return is 5.9%. What is Hack Wellington Co's cost of equity? 19.61% 6.39% 13.87% ? 7.79% Heck wellington Co is financed exclusively using equity funding and has a cost of equity of 12.55%. It is considering the following projects far investment next year: Project Required Investment Expected Rate of Return $22,450 $12,750 13.10% 10.10%Explanation / Answer
Cost of Equity Can be calculated using the CAPM Equation, according to which,
Cost of Equity (or Expected Rate of Return) = Risk free rate + Beta * (Expected market return - Risk free rate)
Cost of Equity (or Expected Rate of Return) = 4.5% + 1.35 * (5.9% - 4.5%) = 6.39%
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Now in this case, cost of equity = 12.55%, and since the project is financed 100% through equity, this is also the WACC or minimum required rate of return.
So, projects with expected return higher than WACC would be selected, which are Projects W, Y and Z.
Adding the required investments in each, total required capital = 22,450 + 19,235 + 17,875 = $59,560
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