Solstice Travel is a online travel business in Southeast Asia. The board is being asked to approve a $193 M capacity expansion that the sponsoring team says will return 12.6%.
The CFO has been using a flat 12% hurdle rate for every proposal for the last four years. A new board member has challenged that, pointing out the capital structure has shifted and rates have moved since it was set.
Current position: the company is funded 26% debt and 74% equity. It borrows at 8.8% pre-tax and pays a 24% effective tax rate. The equity beta is 1.17, the risk-free rate is 6.6%, and the equity risk premium in this market is taken as 5.2%.
The project has roughly the same operating risk as the existing business.
Advise the board. Your answer should provide:
State any assumptions you make.
80 points, 60% to pass.
CAPM for cost of equity, after-tax cost of debt, weight by capital structure, compare project return to WACC, then sensitise.