An entertainment company is interested in launching a new line of clothes under
ID: 2709753 • Letter: A
Question
An entertainment company is interested in launching a new line of clothes under the brand name XYZ in hopes of becoming an international phenomenon. They have surveyed the clothing industry and have identified Style Inc. as the closest pure-play firm for the proposed XYZ division. The company has a beta of 1.45 and is 69% equity-financed. Style Inc. has an equity beta of 2.98 and a debt-equity ratio of 3.96. The risk-free rate of return is 1.6 percent and the market risk premium is 9 percent. What cost of equity should the company use for its XYZ apparel division? Assume taxes are 35% and that the company will maintain its current capital structure for its new apparel division.
Explanation / Answer
Entertainment Company
Cost of equity=Risk free return+beta(market risk premium-risk free return)
=1.6+1.45(9-1.6)
=12.33%
Style Inc
Cost of equity=Risk free return+beta(market risk premium-risk free return)
=1.6+1.33(9-1.6)
=11.442%
The Company use cost of equity of Style Inc for its XYZ apparel division