Question

Markung's Co. is 100% equity-financed company (no debt or preferred stock); hence, its WACC equals it cost of common equality. Markung's Co.'s retained earnings will be sufficient to fund its capital budget in the foreseeable future. The company has a beta of 1.50, the risk-free rate is 5.0%, and the market return is 6.5%. What is Markung's Co.'s cost of equity?

Markung's Co. is financed exclusively using equity funding and has a cost of equity of 12.55%. It is considering the following projects for investment next year:
Project Required Investment Expected rate of return
W $22,450 13.10%
X $12,750 10.10%
Y $19,235 13.60%
Z $17,875 14.60%
Each Project has average risk, and Markung’s Co. accepts any project whose expected rate of return exceeds its cost of capital. How large should next year’s capital budget be?

Answer 1

Markung Cost of Equity:

For this you should use the Capital Asset Pricing Model:

Cost of equity = Risk free rate + Beta * (Market return - Risk free rate)

= 5% + 1.50 * (6.5% - 5%)

= 7.25%

Total capital budget:

They will only pick projects with a rate of return that is higher than 12.55%:

= Project W + Project Y + Project Z

= 22,450 + 19,235 + 17,875

= $59,560