The capital asset pricing model (part 2) - ACCA (AFM) lectures
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53 Comments
Z
Zainab·
I think you have them switched, it should be 50/87.5 hence Be is 0.8943
J
John MoffatTutor·
No - don’t forget that the equity beta will always be higher than the asset beta
J
Joshua·
Example 6 felt like Inception.....
J
John MoffatTutor·
X is not investing in company Y at all. However the gearing used to appraise the new project is the gearing used in the project, not the current gearing of the company.
The asset beta is measuring the risk due to the type of business i.e. ignoring any gearing. So the asset beta of the new project will be the same as the asset beta of Y because they are both involved in shipbuilding.
R
rouquinblanc·
Hello
I understand that we are ungearing the capial structure of company Y to understand risk factor of investing by purely acquiring shares in Y. But in part b we are not changing the captital structure of company Y are we? Company X is just investing by acquiring 50% shares and 50% debt in company Y. This does not modify the capital structure of company Y to 50 50, does it? Tha should depend on how much Comp X is investing in Comp y in proportion to COmpany Ys current capital structure.
Could you please clarify why we are using the Asset beta of comnpany Y with a structure of 20:100 and apply the same asset beta for a modified structure of 50:50 to calculate equity beta?
F
Folabomi·
I have been replaying this part too for like 5x now and I am entirely confused as the Beta of 1.565 was ungeared as it has the D/E ratio of 0.2. I am not sure the calculations for b was correct either. Cos we have simply changed the gearing ratio.
F
Folabomi·
I think I have it figured out now. the Beta of 1.565 is the ungeared beta of Y. While 1.8 given in the question is the geared Beta. Now using the ungeared beta of Y which is a similar company to the shipbuilding company and hence that assumes the Shipbuilding industry has an Asset Beta of 1.565, we can then calculate the Equity beta of this new company using the D/E ratio of 50/50. This equity beta will be specific to the new company.
A
Aadi·
I think here x wants to start a shipbuilding division on its own.Thus,they look at company that already does this that is Y.But y has issued some debt finance so they won't know the beta of the industry.tTo get the beta of the industry,we ungear the beta.For part b look at it like a mini venture that x is undertaking where they are raising 50% equity finance and 50% debt finance.To get the systematic risk in this venture we would need a beta that is geared that's why we use a different gearing ratio in this case.Hope i helped
M
MohamedSupporter·
Great .. Thank you Sir
J
Jiyun·
Thank you for your lecture, and I have a question about gearing in Example 6.
In (a), we used gearing ratio of 0.4 (20:100) to calculate ungeared Beta when it is financed by equity entirely.
In (b), we used ratio of 50:50 to calculate geared Beta when it is financed by equity and debt in the ratio of 50% and 50%.
Why do we use gearing ratio of company (0.4) even when it is entirely financed by equity, while we use the actual ratio between equity and debt to finance the project which is 5:5? If we are to use 50:50 in (b), aren't we supposed to use 0:100 or vice versa; still use 20:100 in (b)?
Appreciate for your response ahead!
J
John MoffatTutor·
In (a) we need to know the beta of the project. We use company Y (because it is in the same business as the project) to calculate the beta, and need to use the gearing of Y to calculate the asset beta. Since in (a) the project is all equity financed, it is the asset beta that determines the discount rate.
In (b) is it the same project (so the same asset beta) but since the project is being financed partly by equity and partly by debt, we need to use the gearing used for the project to calculate the equity beta.
L
Lily·
Hi sir, thank you for your video. In example 6, is the reason why we don't use beta of 1.48 in (b), is because the question is asking to appraise new project? So that's why we are calculating new beta based on Y?
J
John MoffatTutor·
Yes. We appraise based on the riskiness of the new project and find that by looking at Y because Y is in the same business as the new project.
O
Olanrewaju·
Hello John,
Nice video lectures. My question is this:
In Example 6,
1. I noticed that we ungeared Equity beta using the proxy company details to get our Asset beta. Why did we not re-gear the asset beta to get the equity beta using the concerned company's details.
2. Why did we make use of the ungeared beta(Ba) to compute the Cost of Equity and not a re-geared equity beta?
Please correct me where I'm not making any sense.
Thanks
J
John MoffatTutor·
We appraise the project at the rate applicable to the level of risk attaching to the investment. If it is financed all from equity than there is no extra gearing risk attaching to the investment in the project. Therefore we appraise at the cost of equity if it was all equity financed, and if all equity financed then the equity beta is the same as the asset beta.
However, as stated below the example, when there is a major change in gearing then in the exam we take an adjusted present value approach which is explained later.
M
morgan·
hello, im new to this website and i was just wondering where i could find exam questions. i have watched both lectures on capm and have taken notes and i would now like to attempt some exam qestions on this topic.
thanks so much
J
John MoffatTutor·
You need to by a Revision Kit from one of the ACCA Approved Publishers. It is full of past exam questions for practice. and practice is vital for passing the exam.
A
Arjun·
Hello,
On 6B, why did you work out a new Beta derived from the one from part A? And why did you rearrange the formula? Could you not have used the same Beta from part A, to work out the cost of equity in part B?
Thanks
J
John MoffatTutor·
Higher gearing makes the shares more risky and hence the shares have a higher beta.
The formula as it is written gives the asset beta when we know the equity beta. Here we know the asset beta from part (a) and need to calculate the equity beta.
A
Arjun·
Thanks, but don't we have the equity beta from the question which says 1.8?
J
John MoffatTutor·
1.8 is the equity beta of Y. Y has a gearing ratio of 0.2, but the gearing ratio for the new operation is 0.5.
A
Arjun·
Oh right thanks! And the gearing ratio for the new operation is 0.5 because the project is financed by 50% debt?
J
John MoffatTutor·
Exactly :-)
Y
Yinka·
Sir, in calculating the WACC in question 6...why have we assumed 50% as the Market value for both equity and debt. Is the MV for debt not 37.5 (50 x (1.25)? Hence the MV for equity should be 50/87.5 while the MV for debt should be 37.5/87.5. Please clarify.
Y
Yinka·
37.5 = 50 x (1 minus 25 per cent)* correction
K
Kevin·
In determining the cost of equity in part (b), why do we calculate a new equity beta rather than just use the given one of 1.8?
J
John MoffatTutor·
If you are referring to example 6, then 1.8 is the equity beta of Y. We need the equity beta of X and the gearing is different.
B
Baruwa·
Hi Sir,
Thank you the videos. They are highly appreciated. My questions are:
1) If the 1.8 Beta of the Shipping building company has been ungeared giving 1.565 as Beta asset, why do we solve for the 50% cost of equity in question (b) by calculating "Equity / Equity + Debt" again when it already shows that the 1.565 Beta is totally equity with no debt?
2) Why shouldn't the cost of equity in question (b) be calculated as 50% of 1.565 = 0.7825 multiplied by market risk premium of 10% i.e. (18% - 8%) plus the risk free rate of 8% equal to 15.825%?
J
John MoffatTutor·
1. In part (b) there is debt and therefore the risk of the equity will be higher and therefore the beta of equity will be higher. The higher the gearing the great the equity beta and therefore the greater the cost of equity.
2. The same applies as in (1)
N
Noah·
sir why do we not add beta asset of the parent company also to the beta asset of the to-be-bought company (when regearing) to get the overall equity beta of the combined entity?
J
John MoffatTutor·
We take the weighted average of the betas because the overall risk will be somewhere between the two.
Also, taking the weighted average of the asset betas will certainly not give the equity beta of the combined entity - it will give the asset beta.
P
phemmersbach·
Thanks for the videos! I really appreciate your work here!
One question regarding the asset beta formula: why is the market value of debt in the denominator multiplied by (1-T)?
This was not the case in the WACC formula, which is why I am confused.
Thanks in advance for a reply!
M
mukul·
Hi,
I have one doubt regarding the use of WACC as a discount rate.
As per previous lectures you said that WACC used as a discount rate for new project only when we have same gearing ratio so here gearing ratio changed then why you use this as a discount rate .
Thanks
G
guo·
As to example 6 part b, I have no problems in getting BE 2.74 and BA1.565, but why cannot i use the WACC to get the average B of 2.15 and use this beta in CAPM formula to get required rate of 8+2.15(18-8)=29.5%?
M
mothuffar·
Example 6- Part B
Dear sir,
when we Regearing from asset beta to Equity beta, we do that to add our own financial risk to the proxy business risk.
So why we calculate the risk of debt through WACC again?
J
John MoffatTutor·
The WACC isn't calculating the risk of anything. It is calculating the overall cost to the company of their long-term finance.
G
Gnoii·
Dear Sir,
In question (a), required return calculated with asset beta whereas cost of equity calculated with equity beta in question (b). Please help me out of the confusion.
Thank you very much.
G
Gnoii·
Example 6, please.
J
John MoffatTutor·
The asset beta measure the risk of the business itself (and this is part b).
However shares in the business are more risky because the gearing increases the risk of the shares. The risk of the shares is measured by the equity beta (which is part (a)).
A
AK·
In Examples: To calculate the Cost of Debt 8% x 0.75 is taken. This 0.75 is (1-T). The 6% answer is After-Tax Cost of Debt?
J
John MoffatTutor·
Yes.
A
Annamalai·
Hi sir,
In example 6,
Assuming the entire project was going to be funded by Debt finance instead of equity, how would the cost of appraising the project be determined?
a) Will it be using just CAPM , where the best we use is equal to the asset beta of the ship building company (Exactly how we do it in case the project is funded through equity , could you also tell me what is the logic in doing this if we are doing this) , or
b) Will it be based on WACC. (Again, it would be really helpful if you could show an example of how this might be calculated)
U
umartamoor·
Dear Sir,
In Example 5 P plc: Debt to Equity ratio of 0.4
Its mean 40% is Debt and 60% is Equity = 100%
But you solve with 100% as Equity and 40% as Debt = 140% how value of compnay above 100%
Same in Q plc
J
John MoffatTutor·
Nobody is talking about %'s !!!!
It does not mean 40% is debt and 60% is equity - that would mean a debt to equity ratio os 40/60 which is certainly not 0.4!!
If debt to equity is 0.4, then for every $100 equity the debt is 0.4 x 100 = $40.
Therefore for every $140 total value, the equity is $100 and the debt is $40.
O
Olanrewaju·
Great response sir!
I've been having this confusion too.
But, will the same principle apply if the question says that the debt:equity ratio is 40%?
Found this on a professional website:
Question:
An all-equity company operates in an industry where its beta factor is 0.90. It is
considering whether to invest in a completely different industry.
In this other industry, the average debt/equity ratio is 40% and the average beta
factor is 1.25.
The risk-free rate of return is 4% and the average market return is 7%. If the
company does invest in this other industry, it will remain all-equity financed. The
rate of taxation is 30%. Assume that debt is risk-free
Solution:
The appropriate discount rate should be one that applies to the industry in which
the investment will be made. We know that the ‘geared beta’ in this industry is
1.25, with a debt: equity ratio of 40:60. We can calculate the asset beta for the
industry as:
Ba = 1.25 x 60/[60+40(1-0.3)]
= 0.85
Since the company will be all-equity financed, the cost of equity to apply to the
project is therefore:
4% + 0.85 (7 – 4)% = 6.55%.
Kindly help clarify this sir.
I'll be so grateful!
J
John MoffatTutor·
You must ask questions like this in the Ask the Tutor Forum and not as a comment on a lecture.
D
Denay·
In example 6, when calculating the beta of equity, why did you take 87.5/50 rather than 50/87.5 seeing has the formula had not changed sides?
J
John MoffatTutor·
But the formula has 'changed sides'.
We have calculated the asset beta and are using the formula to calculate the equity beta, which means reversing the formula.
D
De Silva·
Hi John
In the final calculation of WACC shouldn't we take the tax effect of debt?
T
toyin1234·
Sir,thank you so much for the wonderful lectures.I would like to know if the 0.2 debt to equity in example 6 can be assumed to be 20% debt and 80% equity to make a total of 100 instead of the 100 equity and 20 debt that you used?A bit confused here sir.Thank you.
J
John MoffatTutor·
No it can't be assumed to be 20% debt and 80% equity.
If the ratio of debt to equity is given as 0.2, then it means that debt divided by equity is 0.2.
If it were 20% debt and 80% equity, then the ration of debt to equity would be 20/80 which is 0.25 !!
The asset beta is measuring the risk due to the type of business i.e. ignoring any gearing. So the asset beta of the new project will be the same as the asset beta of Y because they are both involved in shipbuilding.
I understand that we are ungearing the capial structure of company Y to understand risk factor of investing by purely acquiring shares in Y. But in part b we are not changing the captital structure of company Y are we? Company X is just investing by acquiring 50% shares and 50% debt in company Y. This does not modify the capital structure of company Y to 50 50, does it? Tha should depend on how much Comp X is investing in Comp y in proportion to COmpany Ys current capital structure.
Could you please clarify why we are using the Asset beta of comnpany Y with a structure of 20:100 and apply the same asset beta for a modified structure of 50:50 to calculate equity beta?
In (a), we used gearing ratio of 0.4 (20:100) to calculate ungeared Beta when it is financed by equity entirely.
In (b), we used ratio of 50:50 to calculate geared Beta when it is financed by equity and debt in the ratio of 50% and 50%.
Why do we use gearing ratio of company (0.4) even when it is entirely financed by equity, while we use the actual ratio between equity and debt to finance the project which is 5:5? If we are to use 50:50 in (b), aren't we supposed to use 0:100 or vice versa; still use 20:100 in (b)?
Appreciate for your response ahead!
In (b) is it the same project (so the same asset beta) but since the project is being financed partly by equity and partly by debt, we need to use the gearing used for the project to calculate the equity beta.
Nice video lectures. My question is this:
In Example 6,
1. I noticed that we ungeared Equity beta using the proxy company details to get our Asset beta. Why did we not re-gear the asset beta to get the equity beta using the concerned company's details.
2. Why did we make use of the ungeared beta(Ba) to compute the Cost of Equity and not a re-geared equity beta?
Please correct me where I'm not making any sense.
Thanks
However, as stated below the example, when there is a major change in gearing then in the exam we take an adjusted present value approach which is explained later.
thanks so much
On 6B, why did you work out a new Beta derived from the one from part A? And why did you rearrange the formula? Could you not have used the same Beta from part A, to work out the cost of equity in part B?
Thanks
The formula as it is written gives the asset beta when we know the equity beta. Here we know the asset beta from part (a) and need to calculate the equity beta.
Thank you the videos. They are highly appreciated. My questions are:
1) If the 1.8 Beta of the Shipping building company has been ungeared giving 1.565 as Beta asset, why do we solve for the 50% cost of equity in question (b) by calculating "Equity / Equity + Debt" again when it already shows that the 1.565 Beta is totally equity with no debt?
2) Why shouldn't the cost of equity in question (b) be calculated as 50% of 1.565 = 0.7825 multiplied by market risk premium of 10% i.e. (18% - 8%) plus the risk free rate of 8% equal to 15.825%?
2. The same applies as in (1)
Also, taking the weighted average of the asset betas will certainly not give the equity beta of the combined entity - it will give the asset beta.
One question regarding the asset beta formula: why is the market value of debt in the denominator multiplied by (1-T)?
This was not the case in the WACC formula, which is why I am confused.
Thanks in advance for a reply!
I have one doubt regarding the use of WACC as a discount rate.
As per previous lectures you said that WACC used as a discount rate for new project only when we have same gearing ratio so here gearing ratio changed then why you use this as a discount rate .
Thanks
Dear sir,
when we Regearing from asset beta to Equity beta, we do that to add our own financial risk to the proxy business risk.
So why we calculate the risk of debt through WACC again?
In question (a), required return calculated with asset beta whereas cost of equity calculated with equity beta in question (b). Please help me out of the confusion.
Thank you very much.
However shares in the business are more risky because the gearing increases the risk of the shares. The risk of the shares is measured by the equity beta (which is part (a)).
In example 6,
Assuming the entire project was going to be funded by Debt finance instead of equity, how would the cost of appraising the project be determined?
a) Will it be using just CAPM , where the best we use is equal to the asset beta of the ship building company (Exactly how we do it in case the project is funded through equity , could you also tell me what is the logic in doing this if we are doing this) , or
b) Will it be based on WACC. (Again, it would be really helpful if you could show an example of how this might be calculated)
In Example 5 P plc: Debt to Equity ratio of 0.4
Its mean 40% is Debt and 60% is Equity = 100%
But you solve with 100% as Equity and 40% as Debt = 140% how value of compnay above 100%
Same in Q plc
It does not mean 40% is debt and 60% is equity - that would mean a debt to equity ratio os 40/60 which is certainly not 0.4!!
If debt to equity is 0.4, then for every $100 equity the debt is 0.4 x 100 = $40.
Therefore for every $140 total value, the equity is $100 and the debt is $40.
I've been having this confusion too.
But, will the same principle apply if the question says that the debt:equity ratio is 40%?
Found this on a professional website:
Question:
An all-equity company operates in an industry where its beta factor is 0.90. It is
considering whether to invest in a completely different industry.
In this other industry, the average debt/equity ratio is 40% and the average beta
factor is 1.25.
The risk-free rate of return is 4% and the average market return is 7%. If the
company does invest in this other industry, it will remain all-equity financed. The
rate of taxation is 30%. Assume that debt is risk-free
Solution:
The appropriate discount rate should be one that applies to the industry in which
the investment will be made. We know that the ‘geared beta’ in this industry is
1.25, with a debt: equity ratio of 40:60. We can calculate the asset beta for the
industry as:
Ba = 1.25 x 60/[60+40(1-0.3)]
= 0.85
Since the company will be all-equity financed, the cost of equity to apply to the
project is therefore:
4% + 0.85 (7 – 4)% = 6.55%.
Kindly help clarify this sir.
I'll be so grateful!
We have calculated the asset beta and are using the formula to calculate the equity beta, which means reversing the formula.
In the final calculation of WACC shouldn't we take the tax effect of debt?
If the ratio of debt to equity is given as 0.2, then it means that debt divided by equity is 0.2.
If it were 20% debt and 80% equity, then the ration of debt to equity would be 20/80 which is 0.25 !!