Question: Suppose that firm A is considering entering a business similar to firm B, a relatively small firm in a single line of business. Firm A is currently financed with 65 % debt and 35 % equity. Firm B, the pure-play firm, has a β of 0.85 and is financed with 45% debt and 55 % equity. Firm B’s marginal tax rate is 34 % and firm A’s marginal tax rate is 39 %. If the riskless rate is 3 % and the market return is 8 %, estimate firm A’s cost of equity for the new business using the CAPM.

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