As a result of stockholder pressure, RJR Nabisco is considering spinning off its

Question

As a result of stockholder pressure, RJR Nabisco is considering spinning off its food division. You have been asked to estimate the beta for the division. You decide to so by obtaining the beta of comparable publicly traded firms (often called pure plays). The average (leveraged) beta of comparable firms is 0.9, and the average market value debt/equity ratio of these firms is 0.60. The division is expected to have a debt/equity ratio of 1.20. The marginal tax rate is 36% for all the firms. What is the beta for the food division? The T-bond rate is 3%, and assume a market risk premium of 5% what is the cost of equity of the division?

Explanation / Answer

We will first compute the unlivered beta as below:-

Beta unlivered =beta levered /(1+(1-tax)×(D/E)) = 0.65,

Now we reliver usind new debt equity ratio of 1.2.

A.Beta = 0.65 × (1 + 0.64×1.2) =0.3676

B.As per CAPM Rf + beta×Rm = 3% + 0.3676×5% = 4.83%

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