You have been hired to determine an estimate for the cost of

You have been hired to determine an estimate for the cost of equity for Pizza Pie Company, who is introducing a new line of frozen cookie dough that has been a different level of risk as the firm’s normal operations. Pizza Pie Co. has a debt to equity ratio of 0.65 and a beta of 1.3. Pizza Pie Co has outstanding bonds with a market interest rate of 6% (YTM). Other producers of cookie dough have an average beta of .8 and an average debt to equity ratio of 0.5. The T-bill rate is 4% and the market risk premium is 8.5%. If the corporate tax rate is 40%, what cost of equity should Pizza Pie company use as part of their WACC calculation for the new cookie dough project?

Solution

We should use beta of new industry to calculate new cost of equity for WACC calculation.

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New cost of equity = Risk free rate + Beta of cookie dough industry x Market Risk Premium

New cost of equity = 4% + 0.8 x 8.5%

New cost of equity = 10.80%

We should use 10.80% for WACCcalculation purpose.