Miller Stores has an overall beta of 1.38 and a cost of equity of 12.7 percent for the company overall. The firm is all-equity financed. Division A within the firm has an estimated beta of 1.52 and is the riskiest of all of the company's operations. What is an appropriate cost of capital for Division A if the market risk premium is 7.4 percent?

Question

Quizplus · Accepted Answer

Using the Capital Asset Pricing Model (CAPM), we can calculate the cost of equity for Division A as:

Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium
Cost of Equity = 0 + 1.52 * 7.4%
Cost of Equity = 11.25%

Since Division A is the riskiest division within the company, its cost of capital should be higher than the company's overall cost of equity. Therefore, we can estimate an appropriate cost of capital for Division A by adding a risk premium to the company's cost of equity:

Cost of Capital for Division A = Cost of Equity for Miller Stores + Risk Premium for Division A
Cost of Capital for Division A = 12.7% + (1.52 - 1.38) * 7.4%
Cost of Capital for Division A = 12.7% + 1.036%
Cost of Capital for Division A = 13.74%

Therefore, the appropriate cost of capital for Division A is 13.74%. Option B is the correct answer.

Miller Stores Has an Overall Beta of 1