JKL Corporation is a company devoted primarily to paper products. JKL Corp. has an equity beta of 1.0 and a debt ratio, i.e. a debt-to-asset ratio (D/(D+E)), in market value terms, of 0.3. The company is planning to build a vegetable processing plant. Management plans to maintain this debt ratio in the future. A comparable (vegetable processing) firm, Agro-Corp, has an equity beta of 0.8 and a debt ratio, i.e. a debt-to-asset ratio (D/(D+E)), in market value terms, of 0.2. The risk-free rate is 5% and the estimated market risk premium is 8%. The applicable marginal tax rate is 40%. (A reminder: If a dollar of assets is financed with, say, 60 cents of debt, then 40 cents is financed with equity).
a) What is JKL’s estimated cost of equity for projects that it undertakes in the paper products industry (its current business focus)?
b) Estimate JKL’s asset beta.
c) Estimate the asset beta for the comparable vegetable processing company, Agro-Corp.
d) As stated before, JKL plans to build a vegetable processing plant. It wishes to estimate the cost of equity appropriate for such a plant. What cost of equity should JKL use in this situation?