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?

Question

Quizplus · Accepted Answer

The correct discount rate for Honest Abe's is 12.46%. This is calculated using the Capital Asset Pricing Model (CAPM), which states that the expected return on an asset is equal to the risk-free rate plus a risk premium. The risk premium is determined by multiplying the beta of the asset by the market risk premium. In this case, the beta of Honest Abe's is 1.38, the risk-free rate is 3.5%, and the market risk premium is 8%. Therefore, the expected return on Honest Abe's is 3.5% + (1.38 * 8%) = 12.46%.

Honest Abe's Is a Chain of Furniture Retail Stores