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Dear Sir,
Kindly explain the difference between these two questions and their answers are as given.
15) AJT Co. has a gearing ratio (Debt:Equity) of 30% and pays corporation tax of 25%. A share in AJT has a beta of 1.2. The risk free rate is 5% and the market return is 12%.
What is the cost of Equity for AJT? Ans is a? how?
a) 13.40%
b) 11.36%
c) 16.10%
d) 19.40%16) AJT Co. has a gearing ratio (Debt:Equity) of 30% and pays corporation tax of 25%. A share in AJT has an asset (ungeared) beta of 1.2. The risk free rate is 5% and the market return is 12%.
What is the cost of Equity for AJT? Ans is a? how?
a) 16.10%
b) 19.40%
c) 11.36%
d) 13.40%Is it possible to provide summary workings for the MCQs in the mock to avoid so many questions?. Thanks.
in the first question, you are given the beta of the share. It is the share beta that determines the shareholders required rate of return and therefore the cost of equity.
Cost of equity = 5% + 1.2 (12% – 5%) = 13.4%
In the second question you are given the asset beta. To get the cost of equity we need the share beta and so need to use the asset beta formula.
Asset Beta = (Ve / Ve + Vd (1-T) ) x Equity beta
So, 1.2 = (100 / 100 + (30 x 0.75)) x equity beta
Equity beta = 1.47
So cost of equity = 5% + 1.47 (12% – 5%) = 15.25%
(Sorry – there is obviously another error here 🙁
It will be corrected immediately)If you are unsure about any of the workings above, then you should watch the free lectures on CAPM.
Sorry, but we cannot provide workings in the test itself – the software will not allow it.
Looking at how Kaplan treats it. Would I be wrong there fore to do it as follows and get the above answer? or you still insist it is an error.
Asset Beta = (Ve / Ve + Vd (1-T) ) x Equity beta
So, 1.2 = (70 / 70 + (30 x 0.75)) x equity beta
Equity beta = 1.5857
So cost of equity = 5% + 1.5857 (12% – 5%) = 16.1%
As for the software. It is a matter of expanding the correct or incorrect inputs in the database. May be in future. Thanks very much.
You are right to say it was an error. The above working where 70 is used would apply if gearing was Debt: (Debt+Equity).
Looking at how Kaplan treats it????
Kaplan treats it in exactly the same way as I do – there is only one way of treating it – and of course it was an error on my part.
It depends how the gearing ratio is given – it can be given in two ways (but the examiner always states which way he is using.
It can either be given as the ratio of debt to equity, or it can be given as the ratio of debt to total long-term capital (which is debt + equity).Ooops – I have just seen your last comment, and you have obviously spotted it 🙂
Be careful in the exam though – it is so easy in a hurry to read the wrong way and get the wrong ratio!!
With regard to the software, we paid for the software, and although I appreciate that it can be expanded, it will have to wait until we can afford upgrading the software and can afford the time needed to enter all the workings.
Appreciate that we are providing this website free of charge and our resources are therefore limited.
Maybe in the future we will be able to add the workings, but not for the time being.
Sorry 🙂
Sir – John Moffat!
Some of us may want to contribute to this rich site. It is very helpful and I would like to contribute to this when I am earning.
Please let us know how we can help. Knowledge must be shared and support is critical to this.
Thanks,
16Q is ungeeared beta, equity beta= 1.2 x (70+30(1-0.25))/70 =1,59 and then Ke=5% +1,59(12%-5%)=16,10%
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