The Super Muench Cookie Company is considering a diversification effort that would move it into small retail outlets at major malls around the country. Currently, Super Muench has a capital structure consisting of 30 percent debt and 70 percent equity. Super Muench believes that for the riskier retail outlet portion of its business, a more conservative capital structure of 20 percent debt and 80 percent equity is more appropriate. Super Muench’s current pretax cost of debt is 12 percent. The firm’s average tax rate is 30 percent, and its marginal tax rate is 40 percent.
Another retail cookie company, Dietz’s Dessertery, has been identified. Dietz has a beta (leveraged) of 1.2. Dietz’s current capital structure consists of 40 percent debt and 60 percent equity. Dietz’s tax rate is 40 percent. The risk-free rate is 7 percent and the market risk premium is 7.4 percent.
Super Muench wants to know what risk-adjusted rate of return is appropriate for investments in its retail outlets.