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. 14.08%
C. 12.46%
D. 13.50%
E. 15.54%

Answer 1

Honest Abe's should use a discount rate of 14.54% for a furniture manufacturing project, which is calculated using the CAPM with provided Beta, risk-free rate, and market risk premium.

Step-by-step explanation:

To determine the discount rate Honest Abe's should use for evaluating a furniture manufacturing project, the Capital Asset Pricing Model (CAPM) formula is utilized: discount rate equals the risk-free rate plus the Beta of the firm times the market risk premium. In this scenario, Honest Abe's Beta is 1.38, the risk-free rate is 3.5%, and the market risk premium is 8%. Using the formula, the calculation is as follows: discount rate = risk-free rate + (Beta x market risk premium) = 3.5% + (1.38 x 8%).

Therefore, the discount rate is:

3.5% + (1.38 x 8%) = 3.5% + 11.04% = 14.54%. This is the rate Honest Abe's should use to discount future cash flows from the furniture manufacturing project.

Honest Abe's should use 14.54% as the discount rate when evaluating the new furniture manufacturing project. This rate is calculated using CAPM with the given Beta, risk-free rate, and market risk premium.