If a firm can borrow at 9%,what discount rate should the firm use to discount lease cash flows? (The marginal tax rate for the firm is 35%.)

Question

Quizplus · Accepted Answer

The discount rate should reflect the riskiness of the investment and the opportunity cost of capital. Given that the firm can borrow at 9%, the opportunity cost of capital is at least 9%. However, the cash flows from the lease may not be as risky as the borrowing, so the discount rate may be lower. We can use the after-tax cost of debt as a proxy for the risk-free rate, and add a risk premium to reflect the risk of the lease cash flows. The after-tax cost of debt is 9%*(1-35%) = 5.85%, so the discount rate should be slightly higher than that to reflect the risk premium. Therefore, choice B is the best answer.

If a Firm Can Borrow at 9%,what Discount Rate Should