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The equity beta of Fence Co is 0·9 and the company has issued 10 million ordinary shares. The market value of each
ordinary share is $7·50. The company is also financed by 7% bonds with a nominal value of $100 per bond, which
will be redeemed in seven years’ time at nominal value. The bonds have a total nominal value of $14 million. Interest
on the bonds has just been paid and the current market value of each bond is $107·14.
Fence Co plans to invest in a project which is different to its existing business operations and has identified a company
in the same business area as the project, Hex Co. The equity beta of Hex Co is 1·2 and the company has an equity
market value of $54 million. The market value of the debt of Hex Co is $12 million.
The risk-free rate of return is 4% per year and the average return on the stock market is 11% per year. Both companies
pay corporation tax at a rate of 20% per year.
Required:(b) Calculate a cost of equity which could be used in appraising the new project
Sir just question b.I dont understand why asset beta is needed as CAPM formula w only need equity beta.
I did 4+1.2 (11-4)
thanksIt is the equity beta that determines the cost of equity.
However we need the equity beta of Fence and it will be different from that of Hex because the level of gearing in Fence is different.
So we need to ungear Hex’s beta to get the asset beta, and then we need to regear it using Fence’s gearing to get the equity beta for Fence.
Our free lectures cover this in detail.
(Our free lectures are a complete course for Paper F9 and cover everything needed to be able to pass the exam well)
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