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QUESTION FIVE

A$.$ Kunda and Sitwala Company is considering manufacturing special drill bits and other

equipment for mining rigs. The proposed project is currently regarded as complementary

to its other lines of business, and the company has certain expertise by virtue of its having

a large mechanical engineering staff. Because of the large outlays required to get into the

business, management is concerned that Kunda and Sitwala earn a proper return. Since

the new venture is believed to be sufficiently different from the company's existing

operations, management feels that a required rate of return other than the company's

present one should be employed.

The financial manager's staff has identified several companies $($with capital structures

similar to that of Kunda and Sitwala$)$ engaged solely in the manufacture and sale of mining

drilling equipment whose common stocks are publicly traded. Over the last five years, the

median average beta of these companies has been $1\mathrm{.}28.$ The staff believes that $18$ percent

is a reasonable estimate of the average return on stocks $"$in general" for the foreseeable

future and the treasury bills rate will be around $12$ percent. In financing projects, Kunda

and Sitwala uses $40$ percent debt and $60$ percent equity. The after$-$tax cost of debt is $18$

percent and corporate tax is $35$ percent.

Required

a$)$ Compute the required rate of return for the project

b$)$ Compute the weighted average cost of capital for the project

B$.$ Outline the concept of Capital Asset Pricing Model $($CAPM$)$ and explain the meaning of

Beta $()$ in relation to investments.

$(5$ Marks$)$

C$.$ Explain the implications of systematic and unsystematic risk for investment.

$(5$ Marks$)$

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