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The capital asset pricing model (part 2) – ACCA (AFM) lectures

VIVA

Reader Interactions

Comments

  1. MohamedH says

    July 27, 2024 at 3:56 pm

    Great .. Thank you Sir

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  2. imjy98 says

    November 9, 2023 at 7:56 am

    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!

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    • John Moffat says

      November 10, 2023 at 8:12 am

      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.

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  3. LilyOwens says

    November 8, 2023 at 10:33 am

    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?

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    • John Moffat says

      November 9, 2023 at 7:16 am

      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.

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  4. elarry01 says

    July 5, 2022 at 11:45 am

    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

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    • John Moffat says

      July 5, 2022 at 3:33 pm

      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.

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      • morganpeache says

        April 25, 2023 at 2:55 pm

        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

      • John Moffat says

        April 25, 2023 at 7:50 pm

        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.

  5. arjunh says

    November 24, 2021 at 5:41 pm

    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

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    • John Moffat says

      November 25, 2021 at 8:43 am

      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.

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      • arjunh says

        November 25, 2021 at 1:41 pm

        Thanks, but don’t we have the equity beta from the question which says 1.8?

      • John Moffat says

        November 25, 2021 at 3:15 pm

        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.

      • arjunh says

        November 25, 2021 at 3:56 pm

        Oh right thanks! And the gearing ratio for the new operation is 0.5 because the project is financed by 50% debt?

      • John Moffat says

        November 26, 2021 at 5:49 am

        Exactly 🙂

  6. YkOdus says

    May 7, 2021 at 5:41 pm

    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.

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    • YkOdus says

      May 7, 2021 at 5:42 pm

      37.5 = 50 x (1 minus 25 per cent)* correction

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  7. bobbyv39 says

    April 11, 2021 at 2:58 pm

    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?

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    • John Moffat says

      April 11, 2021 at 3:39 pm

      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.

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  8. Baruwa says

    January 6, 2021 at 6:33 am

    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%?

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    • John Moffat says

      January 6, 2021 at 7:28 am

      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)

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  9. Noah098 says

    November 27, 2020 at 3:28 pm

    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?

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    • John Moffat says

      November 27, 2020 at 4:56 pm

      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.

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  10. phemmersbach says

    July 22, 2020 at 8:51 am

    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!

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  11. mukul1988 says

    May 14, 2020 at 8:49 am

    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

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  12. vincentguo says

    March 1, 2020 at 9:31 am

    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%?

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  13. mothuffar says

    December 30, 2019 at 7:53 pm

    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?

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    • John Moffat says

      December 31, 2019 at 8:51 am

      The WACC isn’t calculating the risk of anything. It is calculating the overall cost to the company of their long-term finance.

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  14. gnoii says

    October 8, 2019 at 5:01 am

    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.

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    • gnoii says

      October 8, 2019 at 5:02 am

      Example 6, please.

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      • John Moffat says

        October 8, 2019 at 7:13 am

        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)).

  15. akhalid93 says

    September 11, 2019 at 11:54 pm

    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?

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    • John Moffat says

      September 12, 2019 at 6:52 am

      Yes.

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  16. annamalai27 says

    August 27, 2019 at 8:16 am

    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)

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  17. umartamoor says

    February 3, 2019 at 6:59 pm

    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

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    • John Moffat says

      February 4, 2019 at 7:40 am

      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.

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      • elarry01 says

        July 21, 2022 at 3:05 pm

        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!

      • John Moffat says

        July 22, 2022 at 6:26 am

        You must ask questions like this in the Ask the Tutor Forum and not as a comment on a lecture.

  18. Denay says

    January 16, 2019 at 10:40 am

    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?

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    • John Moffat says

      January 16, 2019 at 3:29 pm

      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.

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  19. guardian96 says

    December 1, 2018 at 11:26 am

    Hi John
    In the final calculation of WACC shouldn’t we take the tax effect of debt?

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  20. toyin1234 says

    September 10, 2018 at 7:38 pm

    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.

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    • John Moffat says

      September 11, 2018 at 8:34 am

      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 !!

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      • toyin1234 says

        September 11, 2018 at 11:59 pm

        Thank you sir,I do get the logic now.

      • John Moffat says

        September 12, 2018 at 9:22 am

        You are welcome 🙂

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