Ontario Foods uses the SML to determine the cost of equity captial. Currently, t

Question

Ontario Foods uses the SML to determine the cost of equity captial. Currently, the risk-free rate is 5 percent, the expected return on the market is 10 percent, and Ontario's beta is 1.4. The company is considering a proposed project which has an estimated beta of 0.7. What is the project's cost of equity? If selected, the proposed project would represent 20 percent of the firm's total assets. What would the firm's new beta and cost of equity be if it were to accept the project? Ontario Foods uses the SML to determine the cost of equity captial. Currently, the risk-free rate is 5 percent, the expected return on the market is 10 percent, and Ontario's beta is 1.4. The company is considering a proposed project which has an estimated beta of 0.7. What is the project's cost of equity? If selected, the proposed project would represent 20 percent of the firm's total assets. What would the firm's new beta and cost of equity be if it were to accept the project?

Explanation / Answer

Part a)

SML method uses the following formula to determine the cost of equity.

Cost of Equity = Risk Free Rate + Beta*(Expected Market Return - Risk Free Rate)

Since, we are required to estimate the cost of equity for the project, we will use the project's beta and substitute the values provided in the question.

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Solution:

Cost of Equity (Project) = 5 + .70*(10 - 5) = 8.50%

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Part b)

It has been mentioned that the project represents only 20% of the firm's total assets, therefore we will have to calculate the revised beta. Revised beta wil be calculate with the use ofr firm's total beta and project's weight in the portfolio.

New (Revised Beta) = Firm's Beta*Weight of Project = 1.40*20% = .28

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Revised Cost of Equity = 5 + .28*(10 - 5) = 6.40%

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