Question

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?

Answer 1

Answer:

The cost of capital according to CAPM method for Abe will be 12.46%

Their project will be evaluate with this rate.

Explanation:

It will use the CAPM to evaluate the project, as there is no debt, the WACC is not needed.

$Ke= r_f + \beta (r_m-r_f)$  

rf = risk free 0.035

rm = market rate  

premium market = (market rate - risk free) = 0.08

beta(non diversifiable risk) 1.12

$Ke= 0.035 + 1.12 (0.08)$

Ke 0.12460 = 12.46%