The Norris Co. has an improved version of its hotel stand. The investment cost is expected to be $72 million and will return $13.5 million for 5 years in net cash flows. The ratio of debt to equity is 1 to 1. The cost of equity is 13%,the cost of debt is 9%,and the tax rate is 34%. The appropriate discount rate,assuming average risk,is:
A) 8.65%
B) 9%
C) 9.47%
D) 10.5%
E) 13%

Question

Quizplus · Accepted Answer

First, we need to calculate the Weighted Average Cost of Capital (WACC) using the debt-to-equity ratio of 1:1.

WACC = (E/V x Re) + (D/V x Rd x (1-Tc))

where:
E = Equity
D = Debt
V = Total value of the company
Re = Cost of equity
Rd = Cost of debt
Tc = Tax rate

Since the debt-to-equity ratio is 1:1, then:

D/V = 1/2
E/V = 1/2

Plugging in the values:

WACC = (1/2 x 0.13) + (1/2 x 0.09 x (1-0.34))
WACC = 0.065 + 0.0378
WACC = 0.1028 or 10.28%

Therefore, the appropriate discount rate, assuming average risk, is 10.28%.

The closest answer choice to this is C) 9.47%, which is not an exact match but is the closest option available.