Highlight the main points of the case and any issues that you can identify. Analyze and decide.
Question:
Highlight the main points of the case and any issues that you can identify. Analyze and decide. Your answer should have an introduction, body sections in which you answer the question/s regarding the case study, and a conclusion.
Case
CIP is a non-listed company. The Board of Directors has convened a special Board meeting to review two investment opportunities and, at the request of the new Finance Director, decide on an appropriate discount rate, or rates, to use in the evaluation of these investments. Each of the two investments being considered is in a non-listed company and will be financed 100% by equity.
In the past, CIP has used an estimated post-tax weighted average cost of capital of 12% to calculate the net present value (NPV) of all investments. The Managing Director thinks this rate should continue to be used, adjusted if necessary by plus or minus 1% or 2% to reflect greater or lesser risk than the "average" investment.
The Finance Director disagrees and suggests using the capital asset pricing model (CAPM) to determine a discount rate that reflects the systematic risk of each of the proposed investments based on proxy companies that operate in similar businesses. The Finance Director has obtained the betas of two listed companies (Company A and Company B) that could be used as proxies. These are:
Beta
Company A (Proxy for Investment 1) = 1.3
Company B (Proxy for Investment 2) = 0.9
The expected annual post-tax return on the market is 8% and the risk-free rate is 3%.
The Managing Director and the other Board members are confused about the terminology being used in the CAPM calculation and do not understand why they are being asked to consider a different method of calculating discount rates for use in evaluating the proposed investments.