JKL Corporation,a company devoted primarily to paper products,is estimating the cost of equity appropriate for a vegetable processing plant it is planning to build.JKL Corp.has an equity beta of 1.0 and a debt ratio (D/(D+E))of 0.3.A comparable (vegetable processing)firm has an equity beta of 0.8 and a debt ratio of 0.2.Assume a risk-free rate of 5% and a market risk premium of 8%.What cost of equity should JKL use in this situation?
A) 7.7%
B) 11.4%
C) 12.3%
D) 13.0%

Question

Quizplus · Accepted Answer

Unlever the comparable firm's beta: β_A = (E/V)β_E = (0.8)0.8 = 0.64 Then relever at JKL's debt ratio: β_E = β_A/(E/V)= 0.64/(0.7)= 0.91 Cost of Equity: K_E = 5% + 0.91(8%)= 12.3%

JKL Corporation,a Company Devoted Primarily to Paper Products,is Estimating the Cost