Question

Suppose that you are the CFO of ABC Inc., which is an all-equity firm whose beta is 0.5. You are considering a new project that is in the same line of business as ABC Inc.’s existing projects. Assume that the CAPM holds. The risk-free rate is 2% and the market risk premium 6%. What is the discount rate for this new project?

Answer 1

The discount rate for this project is 5%.

Step-by-step explanation:

The discount rate for the new project will be the required rate of return or the cost of equity that will be used to discount the cash flows from the project to calculate its Net present value. Using the CAPM, we can calculate the required rate of return (r) as:

r = rRF + beta * rpM

Where,

• rRF is the risk free rate
• beta is the stock's beta or measure of risk
• rpM is the market risk premium

r = 2% + 0.5 * 6% = 0.05 or 5%