question archive We consider 2 companies A and B whose economic activity is identical, but they differ in their financial structure
We consider 2 companies A and B whose economic activity is identical, but they differ in their financial structure
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We consider 2 companies A and B whose economic activity is identical, but they differ in their financial structure. Their β is equal to 1.2. The risk-free rate is 7% and the average market rate of return is 15%. The marginal tax rate is 20%. Firm A has not in debt and firm B has a debt equity mix of 30%. What is the cost of equity of company B?
a) 18.2%
b) None of these answers is correct
c)18.90%
d) 12%
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| Answer: | |
| Firm A is not in debt, means it has asset beta which is equal to 1.2 | |
| Equity Beta of B = Asset Beta * ( 1 + (1-tax rate)*(Debt/Equity) ) | |
| Equity Beta of B = 1.2 * ( 1 + 0.8*0.3) | |
| Equity Beta of B = 1.488 | |
| As per CAPM, Cost of Equity = Rf + (Rm - RF) * Beta | |
| Cost of Equity = 7% + (15% - 7%) * 1.488 | |
| Cost of Equity = 18.90% | |
| Option C is correct |
