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

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  2. 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!

    • 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.

  3. 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?

  4. 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

    • 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.

      • 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

      • 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. 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

  6. 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.

  8. 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.

  10. 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!

  11. 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

  12. 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%?

  13. 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?

  14. 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.

  16. 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)

  17. 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.

      • 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!

  20. 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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