A privately hold corporation wishes to estimate its cost of equity. The firm has

Question

A privately hold corporation wishes to estimate its cost of equity. The firm has a target debt-to-equity ratio of 0.5 and the marginal tax rate is 35%. The yield on 10 year U.S. Treasury securities is 4% and the expected market risk premium is 6%. It has identified 3 pure play firms with the following equity betas and debt-to-equity rations:

.

Firm ......... Beta ........... D/E Ratio

A ............... 1.8 ............ 0.6

B ............... 1.2 ............ 0.4

C .............. 2.1 ............ 0.8

.

What is the firm's estimated equity beta (levered beta)? What is the cost of equity for the privately held firm?

Explanation / Answer

The estimated equity beta 1.8+1.2+2.1 = 5.1/3 1.7

Hence the average beta of the firm is 1.7

The cost of equity of the firm is given by the CAPM formula:

Re = Rf + Beta*Market risk premium

Re = 4 + 1.7*6 = 14.2%

Hence Cost of equity of the firm is 14.2%

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