Suppose that firm A is considering entering a business similar to firm B, a rela

Question

Suppose that firm A is considering entering a business similar to firm B, a relatively small firm in a single line of business. Firm A is currently financed with 65 % debt and 35 % equity. Firm B, the pure-play firm, has a of 0.85 and is financed with 45% debt and 55 % equity. Firm B’s marginal tax rate is 34 % and firm A’s marginal tax rate is 39 %. If the riskless rate is 3 % and the market return is 8 %, estimate firm A’s cost of equity for the new business using the CAPM.

Check Answer: Firm A’s Cost of Equity = 8.89%

Explanation / Answer

Solution.

.Calculation of Cost of equity.

Riskfree rate = 3%

Market return = 8%

Beta of firm B = 0.85

Beta of Firm A = 1.179

Cost of Equity = 3% + 1.179 ( 3% - 8% )

= 8.89%

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