Assume that Expansion Ltd is a diversified company that is considering an expansion project in a mining division.The company has a target debt-equity ratio of 1:2 and this ratio will not be affected by the new project.The company's manager has identified Dig-it-out Ltd as a company with the same business risk as the new project (equity beta of 1.5).Dig-it-out has a debt-equity ratio of 1:3.Estimate the project's cost of equity for Expansion if the risk-free rate of interest is 7 per cent and the risk premium of the market portfolio is 10 per cent.
A)18.25%
B)22.0%
C)24.5%
D)23.88%

Question

Quizplus · Accepted Answer

1. Calculate the levered beta of Dig-it-out:

βL = βU [1 + (1 - tax rate) x (D/E)]
βL = 1.5 [1+ (1-0.30) x (1/3)]
βL = 1.65

2. Estimate the cost of equity for Dig-it-out:

rE = rf + βL x market risk premium
rE = 0.07 + 1.65 x 0.10
rE = 0.2385 or 23.88%

3. Use the same levered beta to estimate the cost of equity for Expansion:

rE = rf + βL x market risk premium
rE = 0.07 + 1.65 x 0.10
rE = 0.2385 or 23.88%

Therefore, the project's cost of equity for Expansion is 23.88%. The answer is D.

Assume That Expansion Ltd Is a Diversified Company That Is