Question 9.EX.4.4: The CAPM in the investment appraisal process Arclight plc, ...

The CAPM in the investment appraisal process

Arclight plc, a company producing high-quality household lighting products, is considering diversifying into the furniture business. The new venture has an expected return of 15 per cent. Arclight plc will use the CAPM to establish an appropriate discount rate to apply to the new venture and has the following information about three suitable proxy companies.

Furnisure plc
This company has an equity beta of 1.23 and is wholly involved in furniture making. It is financed 35 per cent by debt and 65 per cent by equity.
Home Furnish plc
This company has an equity beta of 1.27 and is also wholly involved in furniture making. It is financed 40 per cent by debt and 60 per cent by equity.
Lux Interior plc
This company has an equity beta of 1.46 and is financed 30 per cent by debt and 70 per cent by equity. It is split into two divisions of equal size: one division produces furniture and the other produces luxury wallpaper. The wallpaper division is seen as 50 per cent more risky than the furniture division.
Other information
■ Arclight plc has traditionally adopted a financing mix of 33 per cent debt and 67 per cent equity, although the project, if accepted, will be financed entirely by equity.
■ The current yield on Treasury bills is 4 per cent and the current return on the stock market is 10 per cent.
■ The corporation tax rate is 30 per cent.
■ Corporate debt can be assumed to be risk-free.

Using the above information, calculate an appropriate discount rate to apply to the new venture and decide whether it should be accepted.