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Assume the following investment opportunity
Assume the following investment opportunity. The company has constant leverage (debt to assets) of 40%, the cost of equity is 22.6%, and the cost of debt is 5.6%. The corporate tax rate is 25%. Investment takes place today, that is at year 0, and equals 30.
What is the relevant rate at which you should discount the free cash flows of the investment opportunity?
Select one:
a. 22.60
b. 9.46
c. 15.80
d. 15.24
Expert Solution
Option d
The relevant discount rate is the WACC
Weight of debt= 40%
Weight of equity= 60%
Cost of debt after tax= 5.6%*(1-25%) = 4.2%
Cost of equity= 22.6%
WACC= weight of debt*Rd+ weight of equity*Re
= 40%*4.2%+60%*22.6%
= 0.1524
=15.24%
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