Suppose the stock of the Quatram Company, a publisher of college textbooks, has a beta of 1.3. The firm is 100 percent equity financed. Quatram is considering a number of capital budgeting projects that will double its size. Because these new projects are similar to the firm’s existing ones, the average beta on the new projects is assumed to be equal to Quatram’s existing beta. The risk-free rate is 5 percent. What is the appropriate discount rate for these new projects if the market risk premium is 8.4 percent?

We estimate the cost of equity, R S , for Quatram as:

Two key assumptions were made in this example: (1) The beta risk of the new projects is the same as the risk of the firm and (2) the firm is all-equity financed. Given these assumptions, it follows that the cash flows of the new projects should be discounted at 15.92 percent.

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Rs.05 + 1.3 x .084 = .05 +.1092 = .1592, or 15.92%