The Chief Financial Officer (CFO) of Action Construction, a publicly traded firm, wants to estimate the cost of common equity. The beta for Action Construction is 1.2. The 10-year Treasury bond rate is 3.42%. The debt to equity ratio is .3 and the corporate tax rate is 40%. The CFO plans to use a market risk premium of 6%.

a. Estimate the cost of equity for Action Construction.

b. XYZ Construction is a small privately held firm. The CFO of XYZ wishes to estimate its cost of equity and plans to use the beta of Action Construction, a firm with similar operations. XYZ has a debt to equity ratio of .5 and a corporate tax rate of 35%. Assume a zero debt beta. Calculate the cost of equity for XYZ based on the above relevant information.

c. Suppose the XYZ Construction CFO hired you to estimate the cost of equity for the firm. What additional information would you need to provide a high quality estimate?

d. Suggest ways to improve the cost of equity estimation process.