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Good evening sir!
in this question we have to calculate the Ke using capm. for the gearing, the question writes the following:
“The gearing ratio for Rover airways, expressed as total debt to total capital (debt plus equity), is 60% and as total debt to equity is 150%”
the answer uses 150% but why? am a little confused on this.
regards
For every 100 of total capital, debt is 60 and therefore equity is 40.
So the debt is 60/40 times the equity.
So for every 1 equity, the debt is 60/40 x 1 = 1.5.
It does not matter what the actual total market value of the equity is, because we are only using ratios in the formula.
So they have treated the equity as being 1 and therefore the debt as being 1.5.(You could use any value for the equity, and then the debt would be 1.5 x that value, and the end result would still be the same.)
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