Question

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?

Answer 1

Answer:

Ke 13% according to CAPM

Explanation:

We calculate the cost of equity using the CAPM

$Ke= r_f + \beta (r_m-r_f)$  

risk free 0.05

market rate  

premium market = (market rate - risk free)= 0.08

beta(non diversifiable risk) = 1

We have to use the beta of the firm.

The beta of a comparable firm is used when we lack information for our own firm.

$Ke= 0.05 + 1 (0.08)$  

Ke 0.13000 = 13%