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Hello,
i am doing this question on a sheet of paper so i don’t know the source,
it is related to cost of capital..Requirement is that i have to calculate cost of capital using capm model, andrew is a civil engineering company, which is planning to purchase a plant for civil engineering project.
Issue is that there are two Betas’ in the question, Andrew has beta of 1.15 while average Beta for civil engineering sector is 1.2
Now since both are in civil engineering sectors, i dont know which beta to use?Do we use company’s Beta in CAPM formula? or Beta of sector?
Without seeing your sheet of paper, I would guess that the problem relates to the fact that published betas are the betas of shares.
If Andrew is a geared company, then the beta of the share will be greater than the beta of civil engineering (because gearing makes the share more risky and therefore makes the beta of the share higher).
Similarly, the beta for the sector will include the effect of the average gearing of the sector.
In theory, the asset betas (i.e. the beta having removed the gearing effect) should be the same for all civil engineering companies. (And the examiner has never confused things by having a different asset beta and he never will!)
If Andrew is financing the new project using the same level of gearing as currently exists in the company, then you should use the beta of Andrew.
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