High Adventure is considering a new project that is similar in risk to the firm\

Question

High Adventure is considering a new project that is similar in risk to the firm's current operations. The firm maintains a debt-equity ratio of .55 and retains all profits to fund the firm's rapid growth. How should the firm determine its cost of equity?

A. By adding the market risk premium to the after tax cost of debt

B. By mulitplying the market risk premium by 1.55

C. By using the dividend growth model

D. By using the capital asset pricing model

E. By averaging the costs based on the dividend growth model and the capital asset pricing model

Explanation / Answer

Answer: Option D - By using the Capital Asset Pricing Model. As the relevant data- Beta of the firms equity, the risk free rate and the market risk premium would be available, presuming that its stock is traded in the market.

A. is incorrect, because cost of equity has no relation to cost of debt.

B. is incorrect, as the multiple of 1.55 indicates total capitalisation in relation to debt.

C. is not appropriate for this firm which retains all its profits and pays no dividends. The dividend growth model

    measures cost of equity using the formula Ke = (D1/Po) + g . As no dividend or its growth is available, this

model is inappropriate.

E. is incorrect, as dividend growth cannot be used. Besides, averaging the two formulae makes no sense.

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