Cost of Capital

Correct Answer: Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is the most commonly used method to estimate the cost of equity for a company. The CAPM takes into account the company's sensitivity to market risk (beta), the expected return of the market, and the risk-free rate to determine the required return on equity. The Dividend Discount Model (DDM) with the assumption of constant dividend growth is a less commonly used method. It relies on the assumption that dividends will grow at a constant rate indefinitely, which may not be realistic for many companies. The Discounted Cash Flow (DCF) model using the company's projected free cash flows is a more comprehensive method of valuing a company, but it is not specifically used to estimate the cost of equity. The DCF model estimates the intrinsic value of a company based on its expected future cash flows, which are discounted back to the present value using an appropriate discount rate (typically the weighted average cost of capital, which includes both the cost of equity and cost of debt).

Correct Answer: The appropriate discount rate is the weighted average cost of capital (WACC), calculated as 40% * 6% * (1 - 0.30) + 60% * 12% = 8.88%. Using this discount rate, the NPV of the project is approximately $115,837.

The correct answer is to use the weighted average cost of capital (WACC) as the appropriate discount rate. The WACC takes into account the proportions of debt and equity in the company's capital structure and their respective costs. To calculate the WACC: Cost of debt after taxes = 6% * (1 - 0.30) = 4.2% WACC = (40% * 4.2%) + (60% * 12%) = 8.88% Using the WACC of 8.88% as the discount rate, the net present value (NPV) of the project can be calculated by discounting the future cash flows. The other answers are incorrect because they use either the cost of equity or the cost of debt alone as the discount rate. The cost of equity is appropriate only for projects financed entirely with equity, while the after-tax cost of debt is appropriate only for projects financed entirely with debt. As Mega Corp has a mix of debt and equity financing, the WACC is the most appropriate discount rate to use.

Correct Answer: The company's credit rating, assuming no new debt is issued

The company's credit rating, assuming no new debt is issued, is least likely to affect the weighted average cost of capital (WACC) among the given options. The WACC is calculated by weighting the costs of debt and equity financing based on the company's target capital structure. If the company does not plan to issue new debt, its current credit rating will not impact the WACC. The other two options, the company's target capital structure and changes in market interest rates, have a direct impact on the WACC. The target capital structure determines the proportions of debt and equity financing, which are key inputs in the WACC calculation. Changes in market interest rates affect the cost of the company's outstanding debt, which is also a component of the WACC.