A privately held 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 21%. The yield on 10 year U.S. Treasury securities is 4% and the expected market risk premium is 6%. It has identified 2 pure play firms with the following equity betas and debt-to-equity rations:
.
Firm ……… Beta ……….. D/E Ratio
A …………… 1.5 ………… 0.3
B …………… 1.3 ………… 0.4
Estimate the firm’s asset beta (unlevered beta) using the pure play firms. Re-lever the asset beta for the firm’s target debt-to-equity ratio to estimate the firm’s equity beta (levered beta). Use that equity beta to calculate the firm’s cost of equity.
What is the cost of equity for the privately held firm?
A.13.2%
B.15.7%
C.12.6%
D.14.4%
E.11.6%
