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Hi,
I was trying to understand this statement from kaplan which is marked correct.
“Be>Ba; WACC<cost of equity calculated using Ba; WACC < cost of equity calculated using Be”
equity beta is greater than asset beta because gearing increase equity risk. if we use equity beta( the geared/risky beta) to calculate the cost of equity we will be getting geared cost of equity which is obviously higher than WACC(as the WACC is reduced by the tax relief). if cost of equity is calculated using asset beta, I thought we will be getting ungeared cost of equity which essentially mean ‘less risky'(Because we are ignoring debt)- Less expectations by the shareholders therefore lower than WACC. Appreciate your help.
Thanks.From what you have written, it seems that you are happy with the first and last of the statements you quote from Kaplan.
As far as the middle statement is concerned (WACC < cost of equity calculated using Ba), this is Modigliani and Miller.
If a company is 100% equity financed then the WACC will be equal to the cost of equity. As a company introduces gearing then although the cost of equity will increase the ‘cheap’ cost of debt will result in the WACC reducing as the gearing increases.
(If you are still unsure then look at Chapter 19 of the Paper FM lecture notes and the illustrative graph I draw when explaining M&M with tax).
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