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

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  1. 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%?

    • 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)

    • 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.

  3. 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!

  4. 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

  5. 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%?

  6. 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?

  7. 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.

  9. 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)

  10. 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

    • 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.

  13. 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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