Use theUse the firm has only been listed on the stock exchange for a short time,you do not have an accurate assessment of Nielson's equity beta.However,you do have the following data for another firm in the same industry: Nielson has a much lower debt-equity ratio of .5,which is expected to remain stable,and Nielson's debt is risk free.Nielson's corporate tax rate is 21%,the risk-free rate is 5%,and the expected return on the market portfolio is 10%.
-Nielson's equity cost of capital is closest to:
A)11.3%.
B)12.2%.
C)14.0%.
D)14.4%.

Question

Use theUse the firm has only been listed on the stock exchange for a short time,you do not have an accurate assessment of Nielson's equity beta.However,you do have the following data for another firm in the same industry:  Nielson has a much lower debt-equity ratio of .5,which is expected to remain stable,and Nielson's debt is risk free.Nielson's corporate tax rate is 21%,the risk-free rate is 5%,and the expected return on the market portfolio is 10%.
-Nielson's equity cost of capital is closest to:
A)11.3%. 
B)12.2%. 
C)14.0%. 
D)14.4%.

Quizplus · Accepted Answer

We need to use the information given to calculate Nielson's equity cost of capital.

First, we use the data for the other firm to calculate its equity beta:

Beta = 1.3 + (1 - 0.65) * 0.7 = 1.215

Next, we can use the following formula to calculate Nielson's equity cost of capital:

Cost of Equity = Risk Free Rate + Beta * (Market Return - Risk Free Rate)

Cost of Equity = 5% + 1.215 * (10% - 5%)

Cost of Equity = 5% + 6.075%

Cost of Equity = 11.075%

However, we need to adjust this number for Nielson's lower debt-equity ratio and tax rate. We can use the following formula:

Cost of Equity = Unlevered Cost of Equity * (1 + (1 - Tax Rate) * Debt/Equity)

Since Nielson's debt-equity ratio is 0.5 and debt is risk-free, we can use the following formula to find the unlevered cost of equity:

Unlevered Cost of Equity = Cost of Equity / (1 + (1 - Tax Rate) * Debt/Equity)

Unlevered Cost of Equity = 11.075% / (1 + (1 - 0.21) * 0.5)

Unlevered Cost of Equity = 9.34%

Finally, we can use the formula above to adjust for Nielson's debt-equity ratio and tax rate:

Cost of Equity = 9.34% * (1 + (1 - 0.21) * 0.5)

Cost of Equity = 9.34% * 1.395

Cost of Equity = 13.01%

Therefore, the closest answer is B) 12.2%.

Use TheUse the Firm Has Only Been Listed on the Stock