Determining the Discount Rate

XYZ (APP) Ltd is a biotechnology company that recently listed on the Australian Securities Exchange (ASX). As such, XYZ Ltd has very limited stock price history and no security analysts following it. XYZ Ltd is company that researches, develops and commercialises new therapies for MacDonald's Disease. XYZ Ltd is entirely equity financed; it has no debt in its capital structure. XYZ has currently has a market capitalisation of around $A200 million and the stock price of around $A2 per share. Prior to listing the company was operating at a loss each financial year. Your group is part of an investment bank that has been hired by XYZ Ltd to advise the board on several issues. Specifically, you have been asked to prepare a report addressing the following criteria:

1. XYZ's limited stock data means the company has no equity beta. Thus, you are required to identify a suitable proxy (or proxies) with which to determine APP's equity beta. You do not need to calculate this beta yourselves. Instead, you may make use of a commercial beta (or betas). You must, however, justify your choice of proxy (proxies).

2. Using relevant market data, you must determine an appropriate required rate of return on equity, using the CAPM model, for the company to use in each of the following situations:

a. In evaluating a one-year time horizon investment project. This nature of this project is consistent with the company's core line of business.

b. In evaluating a ten-year time horizon investment project. This nature of this project is consistent with the company's core line of business.

 c. As the discount rate in pricing an issue of $A40 million in new equity

3. With reference to appropriate peered-reviewed academic literature, you have been asked to justify the choices you have made in determining the discount rate (rates) used for section 2 above.