PLEASE SHOW STEPS: Krile Indus has three projects under considerartion. Proj L i
ID: 2707473 • Letter: P
Question
PLEASE SHOW STEPS: Krile Indus has three projects under considerartion. Proj L is lower than average risk (beta 0.8); Proj A is average risk (beta 1.00); Proj H is higher than average risk (beta 1.20). You have gathered the following information to determine if one or more of these projects has an acceptable rate of return for the firm:
1. Sources of financing: 50% debt and 50% equity
2. Average beta for Krile Indus = 1.00
3. Rd = 8% before taxes (tax rate = 30%)
4. Rm = 12%
5. Rf = 3%
6. IRR (L) = 9%
7. IRR (A) = 10%
8. IRR (H) = 11%
Calculate the required rate of return for each project AND determine which, if any, projects are acceptable
Explanation / Answer
the required rate of return for each project AND determine which, if any, projects are acceptable
Step 1: Calculation of Cost of Equity for each project
Cost of equity = Rf + (Rm-Rf)*Beta
Project L = 3 + (12-3)*0.80 = 10.20%
Project A = 3 + (12-3)*1 = 12%
Project H = 3 + (12-3)*1.20 = 13.80%
Step2: Calculation of Cost of debt after tax for each project
Cost of debt after tax = Rd*(1-tax rate)
Project L = 8*(1-0.30) = 5.60%
Project A = 8*(1-0.30) = 5.60%
Project H = 8*(1-0.30) = 5.60%
Answer 1) :
Step3: Calculation of WACC or required rate of return for each project :
WACC = Weight of debt * Cost of debt after tax + Weight of Equity * Cost of equity
Project L = 0.50 *5.60 + 0.50*10.20 = 7.90%
Project A = 0.50 *5.60 + 0.50*12 = 8.80%
Project H = 0.50 *5.60 + 0.50*13.80 = 9.70%
Answer 2)
Step 4: Calculation of alpha of each project
Alpha = IRR -WACC
Project L = 9-7.90 = 1.10%
Project A = 10- 8.80 = 1.20%
Project H = 11-9.70 = 1.30%
Since alpha of all project are positive , All projects are acceptable
If Project are choosen among them then Project H's alpha is higher, so Project H is acceptable among the other two .