Question

DeAndre Hunter Enterprises has found that its common equity capital shares have a beta equal to 1.5 while the risk-free return is 8 percent and the expected return on the market is 14 percent. The firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt, and 35 percent is the marginal tax rate.

The firm has semiannual bonds outstanding with nine years to maturity and are currently priced at $754.08. The bonds have a coupon rate of 7.25 percent. The face value on a bond is $1,000. The firm will invest $300,000 in a five-year project today that will produce annual cash flows of $80,000.

What is the cost of equity for the firm?

Answer 1

Solution :-

Risk free rate ( R_{​​​​​​f} ) = 8%

Beta of common equity = 1.5

Expected return on market ( R_{​​​​​​m} ) = 14%

Cost of equity will be computed using capital asset pricing model (CAPM)

so, Cost of Equity (r) =

= Risk free rate + Beta ( Expected market return - Risk free rate )

= 8% + 1.5 ( 14% - 8% )

= 8% + 1.5 ( 6% )

= 8% + 9%

= 17%

So, cost of equity for firm is 17%