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Please help with the following:
when we calculate an asset beta of a combined company (or when we are deducting the asset beta of one activity having the total asset beta and the proportion of capital (debt and equity) allocated to each activity) we use the next equivalence:
total Asset Beta=Asset Beta1 X p1 + Asset Beta2 x p2
I have a question regarding the p term:
p1 is the proportion of equity of company1/total combined equity or the proportion of capital (equity+debt) of company1/total combined capital?I met both variants, and the results cand be slightly different depending on which variant is chosen. I guess because we always assume the beta of debt is 0 we can use the equity proportion….. but which variant to choose in the exam?
Thank you.
The asset betas are always the betas assuming no gearing in the business. So equity, and equity+debt are the same thing (nothing to do with the debt beta being zero, but because there is no debt)
You say two variants, but there are not. It may be the wording that has confused, but if you tell me a past exam question where you are not sure then I will explain 🙂
(What may be causing your confusion is that if the level of gearing does not change, then just as the total asset beta is the weighted average of the individual asset betas, so too the total equity beta will be the weighted average of the individual equity betas. This is because if the gearing does not change then the relationship between the equity and asset betas will be unchanged)
Thank you for your reply.
I try to be more specific. Q1/June 2011
Combined Company: Cost of capital calculation
Asset beta (Pursuit Co) = 1·18 x 0·5/(0·5 + 0·5 x 0·72) = 0·686
Asset beta (Fodder Co) = 1·53 x 0·9/(0·9 + 0·1 x 0·72) = 1·417
Asset beta of combined co. = (0·686 x 140,000)/(140,000 + 40,095) + 1·417 x 40,095)/(140,000 + 40,095) = 0·849In calculation of combined asset beta here:
we use the proportion of Pursuit (debt+equity) market value(140.000) / market value (debt+equity) of combined (140.000+40.095) * it s asset beta (0.686) + the proportion of Fodder market value/market value of combined * it s asset beta (0.849)but in other instances
we will use only the proportion of EQUITY of Pursuit/combined value of EQUITY of combined *it’s asse beta (0.686)+ the proportion of EQUITY of Fodder/combined value of EQUITY *it’s asse beta (0.849)That is confusing me one time we use to proportionate asset beta only the EQUITY of the two separates companies per total equity of combined and in other examples equity is replaced by equity+debt!
For example in q4 2012:
1·217 = component asset beta x 0·25 + 1·078 x 0·75 (0.75 and 0.25 – are the proportion of EQUITY and not of the total capital (equity+debt).In other words how are the weighted averages of the individual asset betas calculated:
1. as a proportion of company total (equity+debt) market value /market value of combined (debt+equity) or
2. only equity market value of each company/equity market value of combined.There are two ways of calculated this weigheted averages of individual asset betas.
Thank you!My original answer is the correct way of doing it.
The only reason the answer to this question does it the way it does (which is strictly not correct) is because the question specifically tells you to do it that way. (It is the sentence just above ‘other information’)
I’m sorry for bothering you but I want to be sure I understand clear.
The total asset beta is the weighted average of the individual asset betas if and only if level of gearing does not change?
In Bpp text book for type III acquistion (so both financial and business risk does change) there is a standard procedure “to calculate the average asset beta….”
In Q4 June 2012
we have Elfu portfolio (2 activities) asset beta 1.217
we have Elfu asset beta of one activity 1.078
and again we calculate the second activity asset beta using an weigheted average:
1.217= second avtivity asset beta x 0.25+ 1.078 (1st actvity asset beta) x 0.75where 0.25 and 0.75 are the proportion of equity allocated to the 1st respective 2nd activity (but the debt are allocate in different proportion 0.2 to 1st activity 0.8 for 2nd activity).
This is another exeption that should have been mentioned in the question (?Thank you again, promise this is the last question on this issue.
You will hate me for saying this, but again strictly the examiners answer is not quite correct.
However given the way that the question was worded (the way they said how much of the equity and debt was for other products) there wasn’t really much else he could have done.
(and is does say a ‘reasoned estimate’ – his answer is a reasoned estimate even though it is strictly not quite correct).
Don’t make things harder for yourself – it was 8 marks and so there is a limit as to how much could be expected. Also, there is very rarely ever one correct answer in P4 – the marks are not for the final answer but proving that you understand the ideas.
If you are ever not sure, then just state your assumption and provided it is at all sensible (and you have done the correct workings on that assumption) you would get full marks.Sorry for bothering you this issue again but I want to understand it really clear.
In calculation for Type III Acquisition (in Text Book BPP), step 2 refers to calculation of AVERAGE ASSET BETA for the group after acquisition.
However, I wonder what is “average asset beta” ? Is it “weighted average asset beta” ? If so, what is the WEIGHTING for each asset beta of individual company? the proportion of equity to combined equity or proportion of capital (equity+debt) to combined capital (combined equity + combined debt)
For example. Company A wants to acquire Company B.
Capital of A: Debt: $500m, Equity $500m, total capital $1000m (including finance for acquisition)
Capital of B: Debt: $100m, Equity $300m, total capital $400mAsset beta of A: 1.5
Asset beta of B: 2So the average asset beta for the group post-acquisition is:
1.5×500/(500+300) + 2×300/(500+300) : the weighting is proportion of individual equity to combined equity
or:
1.5×1000/(1000+400) + 2×400/(1000+400) : the weighting is proportion of individual capital (debt+equity) to combined capital
?
Which way is correct in the exam?
The average asset beta is indeed the weighted average asset beta.
As to the weighting to be used, the examiner has been a little inconsistent in his answers, but best is to weight by the market values of the equity (since it is the equity that carries the risk) unless of course the question says to do different.
Whatever you do, state as always your assumptions – there is rarely just one ‘correct answer’ and if you state your assumptions and they are sensible then you get the marks.
hey, I have a problem with q1 of Sep/Dec 2015 exam paper. In the appendix 2 they calculate ‘Combined company equity beta’ and they use the proportion of equity/debt of 0.6/0.4. It is said in the question that this proportion is for the Cigno Co, the other company Anatra has non-current liab. of 9,000; equity of 3,500 and reserves of 4,520. How do we arrive to the equity/debt proportion of 0.6/0.4 in the combined company?
thanks in advanceThe question says (in the section about “Additional information”) that the debt to equity ratio is 40:60, and that it will be maintained.
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