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Cost of Equity: Academic Approach

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Scenario: A privately held corporation wishes to estimate its cost of equity. The firm has a target debt-to-equity ratio of 0.5 and the marginal tax rate is 35%. The yield on 10 year U.S. Treasury securities is 4% and the expected market risk premium is 6%. It has identified 3 pure play firms with the following equity betas and debt-to-equity rations:

Firm ........... Beta ......... D/E Ratio
A ................ 1.8 ............ 0.6
B ................ 1.2 ............ 0.4
C ................ 2.1 ............ 0.8

What is the cost of equity for the privately held corporation?

a. 18.06%
b. 14.2%
c. 11.26%
d. 12.4%
e. 13.6%.

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The solution examines the cost of equity for an academic approach.

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