Question

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? Multiple Choice 13.12 percent 13.74 percent 12.63 percent 12.77 percent 13.01 percent

Answer 1

Answer:

MILLER STORES

Ke = Rf + β(Market risk premium)

12.7 = Rf + 1.38(7.4)

12.7 = Rf + 10.212

Rf = 12.7 - 10.212

Rf = 2.488%

DIVISION A

Ke = Rf + β(Risk premium)

Ke = 2.488  + 1.52(7.4)

Ke = 2.488 + 11.248

Ke = 13.74%

Explanation:

First and foremost, we need to calculate risk-free rate using the data relating to Miller Stores. In this case, the cost of equity, beta and market risk premium of Miller Stores were provided with the exception of risk-free rate. Then, we will make risk-free rate the subject of the formula.

We also need to calculate the cost of capital of division A, which is risk-free rate plus beta multiplied by the market risk-premium.