Question

1. Metrocity Inc. is a private company and interested in determining its cost of equity. Bistro Inc. is very similar to Metrocity and its stock is publicly traded. Bistro’s common stock has a beta of 1.5 and its debt ratio is 1/3. Metrocity Inc., on the other hand, is an all-equity firm. If the expected market premium is 5% and the risk-free rate is 3%, what is Metrocity’s cost of equity? (Assume debt beta is zero and that there are no corporate taxes).

1. 8%
2. 11%
3. 15%
4. 17%
5. 23%

Answer 1

Metrocity Inc & Bistro Inc are very similar & public traded companies.

Equity Beta of metrocity = 1.5

Debt ratio of Bistro = 1/3 which means Equity ratio is 2/3

& Debt-Equity ratio is 1/2

Calculating Unlevered beta of Bistro

Unlevered beta = Equity Beta/[1+(1- Tax rate)*Debt/Equity]

Unlevered beta = 1.5/[1+(1-0)*1/2]

Unlevered beta = 1.5/1.5

Unlevered beta = 1

Since, metrocity & Bistro are similar Company there Beta will also be similar.

Unlevered beta of Metrocity = 1

calculating metrcity's Equity cost of Capital:-

Equity cost of Capital = Risk Free return + Unlevered beta*(Market risk Premium)

Equity cost of Capital = 3% + 1(5%)

Equity cost of Capital = 8%

SO, Metrocity’s cost of equity is 8%

Option A

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