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Dear John,
I am confused using the gearing ratio. In the example 11 of Chapter 10 in the Ungearing Beta section of the Notes.
In the example the gearing ratio (debt to equity) of 0.4 was given
I think that means that the debt is 40% of the equity. (i.e. 40 /40+60).
But you say that equity is 100 so while doing WACC for part c) of the question in proportion column you take (40/140) and not taken 40/100 for debt and 60/100 for equity.
Similarly you use similar proportions while calculating Ba as well in part c)Similarly in part a) you took equity 100 and debt 20 and not 80 and 20 respectively.
Kindly clear my confusion. I am really worried
Further, if in exams if question says Equity : Debt ratio is 3:1 so what should I do for calculating WACC and Ba
Further, if in exams if question says Equity is 70 % and Debt is 30% so what should I do for calculating WACC and Ba
I will be really grateful if you explain with simple example.
Regards
Be very careful, because gearing can be given in two ways.
If it is given as debt to equity of 0.4, then it means that the debt is 40% of the equity.
(The reason your answer is wrong is that if debt were 40 and equity 60, then the ratio of debt to equity would be 40/60 which is not 0.4. You answer would only have been correct if the ratio had been expressed as debt to total capital (i.e. debt + equity).If the question were to say that the equity:debt ratio is 3:1 then it would mean that the equity was three times the debt. So you could use debt of 100 and equity of 300 in the formula. (The exact values do not matter – only the ratio – so using debt of 100 and equity of 300 would be in the correct ratio.)
If you were told equity 70% and debt 30% then it must mean that they are 70% and 30% of the total long-term finance (since they add up to 100% 🙂 ), and so you would use equity 70 and debt 30 in the formulae.
Sir John,
Thanks for clarifying my confusion.
I will take care for this while practising the questions.
You said above that “using debt of 100 and equity of 300 would be in the correct ratio.”
means that while calculating WACC i use in the proportion column as :
Equity 300/400 and for debt 100/400 . Am I right.Thanks again in Advance.
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