Advanced Systems Company is financed one-third with debt and two-thirds with equity. Its market beta has been estimated to be 1.5. The current risk-free rate is 8 percent, and the expected market return is 15 percent. Advanced Systems’ tax rate is 40 percent. Advanced Systems is planning a major research and development (R&D) investment program. Advanced Systems’ management believes that these types of projects should be financed conservatively. Specifically, the company plans to finance all R&D investments with 90 percent equity and 10 percent debt.
a. If the pure project beta for the R&D investment is the same as the pure project beta for Advanced Systems’ other assets, what rate of return is required on the equity-financed portion of the R&D investment, assuming it is financed 90 percent with equity and 10 percent with debt?
b. Advanced Systems’ managers believe this project may have more risk than their other investments .Another firm that invests very heavily in R&D similar to the type proposed by Advanced has been identified. Its capital structure is 80 percent equity and 20 percent debt. Its tax rate is 35 percent, and its market beta is 1.6. Using this information, determine the required return on the equity-financed portion of Advanced Systems’ R&D project, assuming it is financed 90 percent with equity and 10 percent with debt.