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If a geared company asset beta is used in the CAPM formula(rj = rf +beta j(rm-rf)) what will rj represent?
A.The WACC of the company
B.The ungeared cost of equity
C.The geared cost of equity
D.The market premium
Correct answer is B but can you please explain meIt is the beta of a share (the equity beta) that determines the cost of equity.
If the company is geared then the equity beta will be higher than the asset beta (and the cost of equity will be higher than it would be if there is no gearing).
Using the asset beta in the formula is only dealing with the business risk and is ignoring the risk due to the gearing.
Therefore using the asset beta in the formula will give the cost of equity ignoring the gearing – i.e. the ungeared cost of equity.
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Sir as you said that It is the equity beta that determines the cost of equity. So here you meant to say geared cost of equity na?
However, asset beta will determine ungeared cost of equity. Right?
The equity beta always determines the cost of equity.
If there is no gearing then the equity beta will be the same as the asset beta.
If we use the asset beta in the formula then it gives the cost of equity if there is no gearing (the unguarded cost of equity). If there is gearing then the equity beta is higher than the asset beta and gives the cost of equity with gearing.
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