Corporate Finance

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Corporate Finance

Pure play βL D/V

A 1.1 0.3

B 0.9 0.25

C 0.95 0.35

D 1 0.3

The asset betas for the pure plays are:

Firm Aβ

A 0.77

B 0.675

C 0.6175

D 0.7

Average βA = 0.7.
This is taken as proxy asset beta of the project.
Now, levered beta for the project = βE = βA/(E/V)
= 0.70/0.7 = 1.0
If
Rf= 11 percent
(RM – Rf) = 10 percent
Cost of equity for the project = Rf + βL [E (RM) – Rf]
= 11 + 1.0[10 percent]
= 21 percent

WACC = d Ke

V

E

TK

V

D

)1( +−

The project’s debt to value ratio is to be used in WACC calculation.

Certainty Equivalent

Under the Certainty Equivalent method, the risky cash flows are adjusted downwards by a risk adjustment
factor and converted into a series of certain cash flows. The series is to be discounted using a risk free rate.
The higher the uncertainty regarding the realization of the cash flow, the lower is its value today, that is, the
lower the certainty equivalent:

∑

= +

=

N

t

t

t

tt

i

EL

1 )1(

NPV

where

Lt= Certainty equivalent factor

=

t

t

K

i

+

+

1

1

it= risk free rate of return in period t, and

Kt= risk adjusted discount rate in period t.