Backyard Tavern has a beta of 1.5 and a cost of equity of 13.2 percent. The risk-free rate of return is 4.2 percent. Backyard is considering a project with a beta of 1.7 and a project life of eight years. An
Appropriate discount rate for the project is:

Question

Quizplus · Accepted Answer

The appropriate discount rate (cost of equity) for the new project can be calculated using the Capital Asset Pricing Model (CAPM):
Cost of equity = Risk-free rate + Beta * (Market risk premium)
Market risk premium can be assumed to be around 5-6%.
Using the given information,
Cost of equity for Backyard Tavern = 13.2%
Beta of Backyard Tavern = 1.5
Risk-free rate = 4.2%
Market risk premium = 5.4% (assuming an average market risk premium of 5-6%)
Using CAPM,
13.2% = 4.2% + 1.5 * (5.4%)
Solving for Beta of the new project,
Beta of new project = (Beta of Backyard * project life) / (Beta of Backyard * project life + 1) = (1.5 * 8) / (1.5 * 8 + 1.7) = 1.238
Using CAPM,
Cost of equity for new project = 4.2% + 1.238 * 5.4% = 11.96%
Adjusting for project risk and uncertainty, the appropriate discount rate would be slightly higher than the cost of equity for the new project. Therefore, the best choice is C) 14.40%.

Backyard Tavern Has a Beta of 1