Suppose IBM is considering whether to undertake a project that has similar risk

Question

Suppose IBM is considering whether to undertake a project that has similar risk characteristics to the overall firm. The equity beta of IBM is 1.32, the risk free rate is 10%, and the return on market portfolio is 25%. Suppose too that the company’s total assets are $100 million, with debt at $40 million and value of its stock $60 million. Its debt is known to be risk free. Assume no taxes. The rate of return the company will choose to evaluate the project is


1. 29.8%.
2. 21.88%.
3. 19.28%.
4. 16%.
5. 24.22%.

Explanation / Answer

Cost of equity = 10% + (25% - 10%)*1.32 = 29.80% Cost of debt = 10% WACC = (40/100)*10% +(60/100)*29.80% = 21.88% Thus, the rate of return the company will choose to evaluate the project is 21.88% Correct option '2. 21.88%.'

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