Question

Honest abe’s is a chain of furniture retail stores. integral designs is a furniture maker and a supplier to honest abe’s. honest abe’s has a beta of 1.38 as compared to integral designs' beta of 1.12. both firms carry no debt, i.e., are 100% equity financed. the risk-free rate of return is 3.5 percent and the market risk premium is 8 percent. what discount rate should honest abe's use if it considers a project that involves the manufacturing of furniture?

A. 12.92%
B. 13.50%
C. 14.08%
D. 15.54%
E. 12.46%

Answer 1

Using the CAPM formula, Honest Abe's discount rate for furniture manufacturing projects is calculated to be 14.54%, corresponding with option D.

Step-by-step explanation:

To determine the discount rate Honest Abe's should use for a project involving the manufacturing of furniture, we will apply the Capital Asset Pricing Model (CAPM), which is expressed as:

Discount Rate (Cost of Equity) = Risk-free rate + (Beta × Market risk premium)

Given Honest Abe's beta is 1.38, the risk-free rate is 3.5%, and the market risk premium is 8%, we can calculate its discount rate as follows:

Discount Rate = 3.5% + (1.38 × 8%)

Discount Rate = 3.5% + 11.04%

Discount Rate = 14.54%

Hence, Honest Abe's should use a discount rate of 14.54% for its furniture manufacturing project, which corresponds with option D.

• Calculate Honest Abe's discount rate by applying the CAPM formula.
• The resulting discount rate is 14.54%, indicating the rate at which future cash flows should be discounted to assess the project's value.