2. The following table gives the information about two companies, where the debt

Question

2. The following table gives the information about two companies, where the debt and equity are in millions of dollars.

Company

Debt

Equity

Cost of debt

Tax rate

Business

Glasgow Airline

$117

$351

1.6

9%

33%

Airline

Edinburgh Hotels

$ 15

$ 60

1.5

8%

32%

Hotels

The risk-free rate is 4% and the expected return on the market 11%. Glasgow Airline wants to buy a hotel using its existing capital. Find the required rate of return on the acquisition.

Company

Debt

Equity

Cost of debt

Tax rate

Business

Glasgow Airline

$117

$351

1.6

9%

33%

Airline

Edinburgh Hotels

$ 15

$ 60

1.5

8%

32%

Hotels

Explanation / Answer

Glasgow is purchasing the Edinburgh hotel using its existing capital.

As per CAPM model, the required rate of return for the acquisition-

R = Rf + b (Rm -Rf), where R = Required rate of return, Rf= Risk free return & Rm=Expected return on the market, b = Beta

Putting the values in above formula we get-

R = 0.04+1.5*(0.11-0.04)

or R = 0.145= 14.5%

Hence required rate of return is 14.5%

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