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For the part B,
In the past year paper JUNE 2012 TISA CO
in the part (A) in calculating cost of equity(to get cost of capital),
1. when we look at the answer sheet to get the component asset beta, answer sheet have used 75% equity finance and 25%. However, the question also includes 80% of Elfu co’s debt finance. Then when do we actually use 80% of this debt finance ?
2. Moreover, answer sheet used 75%(Equity finance) and 25% (debt finance) but how do we know which one to use. (80% debt finance and 20% equity finance) or (75% equity finance and 25% debt finance) where both are attributed to other activities excluding the component production ??
thanks John !
If I am understanding your question correctly, then these are two separate issues.
Firstly, with regard to the component asset beta, the answer has used the %’s of equity finance on the basis that it is equity that is carrying the risk.
With regard to the calculation of the WACC, we use Tisa’s capital structure (debt to equity), because the question says that Tisa’s capital structure is unlikely to change following the investment.
Then
when do we actually use 80% of Elfu Co’s debt finance and 20% of equity finance ?( as the question states that this 80% and 20% also can be attributed to other activities excluding the component production)
The question says that 80% of debt and 75% of equity are attributed to other activities.
So when calculating the asset beta of other activities, we use 75% of the equity (75% x 480M) and 80% of the debt (80% x 96M).
1. For component asset beta in the answer sheet, why do we multiply with 75% ? not 25% ?
2. For calculating component asset beta, why can’t the formula be
1.217 = ( Component asset beta x 0.8 ) + ( 1.078 x 0.2 )
Since 80% is also attributable to other activities.
1. We multiply the asset beta for other activities by 75%, because 75% of Elfu’s equity is attributed to other activities. We multiply the asset beta for component by 25% because if 75% is in other activities, then 25% is in the components.
2. Using 80% and 20% would be nonsense. Those %’s relate to the debt finance, and the asset betas are the betas without any gearing.
“Because the question says that Tisa’s capital structure is unlikely to change following the investment.”
Sir,
Lets say, just for the sake of argument, if Tisa’s capital structure changes following the investment process, then what do we do? Pls Advise.
Thank you in advance for your explanation
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