Question

Procter & Gamble has two divisions: Beauty/Grooming and Household Products. Suppose P&G’s debt-equity ratio is 0.19 and its tax rate is 20%. The average beta for 27 firms in the Household Products sector is 0.98 with average debt-to-equity for those firms of 23.5%. The average beta for 14 firms in the Toiletries/Cosmetics sector is 1.17 with average debt-to-equity of those firms of 16.4%. Assume the average tax rate for each sector is 21%. If the risk-free rate is 4% and the market risk premium is 5.5%, what should P&G use as cost of equity for each of its two divisions?

Answer 1

For beauty/grooming division

Average levered beta in Toiletries/Cosmetics sector is 1.17 with average debt-to-equity of 16.4% and average tax rate of 21%

Unlevered beta = Levered beta / (1+(1-taxrate)*D/E)

=1.17/(1+(1-0.21)*0.164) = 1.0358

This beta can be taken as a proxy for P&G's beauty/grooming division as well

Levered beta for P&G's beauty/grooming division = Unlevered beta* (1+(1-tax rate of P&G)*D/E ratio of P&G)

=1.0358*(1+(1-0.2)*0.19)

=1.193243

So, Cost of Equity for P&G beauty/grooming division = Risk free rate + Beta * market risk premium

=4%+5.5%*1.193243

=10.56284%

For Household products division

Average levered beta in the Household Products sector is 0.98 with average debt-to-equity for those firms of 23.5%. and tax rate of 21%

Unlevered beta = Levered beta / (1+(1-taxrate)*D/E)

=0.98/(1+(1-0.21)*0.235) = 0.826551

This beta can be taken as a proxy for P&G's Household products division as well

Levered beta for P&G's household products division = Unlevered beta* (1+(1-tax rate of P&G)*D/E ratio of P&G)

=0.826551*(1+(1-0.2)*0.19)

=0.952187

So, Cost of Equity for P&G household products division = Risk free rate + Beta * market risk premium

=4%+5.5%*0.952187

=9.237%