Scholastic Toys is considering developing and distributing a new board game for children.The project is similar in risk to the firm's current operations.The firm maintains a debt-equity ratio of 0.40 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 aftertax cost of debt
B)by multiplying the market risk premium by (1 - 0.40)
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

Question

Quizplus · Accepted Answer

The most appropriate method for determining the cost of equity for Scholastic Toys is the capital asset pricing model (CAPM), which takes into account the risk-free rate, the market risk premium, and the firm's beta. The firm's debt-equity ratio is irrelevant in this calculation. Since the project is similar in risk to the firm's current operations, the beta of Scholastic Toys may be used as a reliable measure for the new project. Therefore, the CAPM is likely to provide the most accurate estimate of the required return on Scholastic Toys' equity for the purpose of evaluating the new project's expected financial performance.

Scholastic Toys Is Considering Developing and Distributing a New Board