Energy Corp. has a market capitalization of $15 billion and debt with market val

Question

Energy Corp. has a market capitalization of $15 billion and debt with market value of $5
billion. Energy will keep its current Debt-to-Equity ratio constant. The equity cost of capital
is rE = 10% and the cost of debt is rD = 6%. The corporate tax rate is 35%. Assume a market
risk premium of 6% and a risky-free rate of 5%.

The firm is considering an expansion project (i.e., same risk as the firm’s assets) with the
following cash flows:

Assume that the project is not an expansion project within Energy’s line of business
(i.e., different risk). BigKup, a public firm, is believed to meet the requirements for
a comparable firm. BigKup has an equity Beta of 1.5 and a debt-to-equity ratio of 1.
BigKup can borrow at the risk free rate. What should the project’s discount rate be if
the project were financed with equity only?
(A) 9.5%
(B) 10.5%
(C) 11.0%
(D) 14.0%

Explanation / Answer

Beta equity=Beta asset*(1+(D/E)*(1-tax))

beta Asset=1.5/(1+1*(1-35%))

=0.91

Expected return= Risk free+(beta*market risk premium)

=5%+(0.91*6%)

=10.5%

It i soption B

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