In a geared company, we remove their equity beta and incorporate the asset beta to determine the project-specific cost of equity in our company.

If we are given a scenario where the new company’s business that we are trying to imitate is financed purely by equity, obviously their beta would only reflect the unsystematic risks of shares. How do we calculate the risks of their business asset beta only in order to determine the project specific cost of equity?

If there is all equity finance, then the equity beta is the same as the asset beta. The only reason that the equity beta is ever more than the asset beta is because of the extra risk created by the gearing.

Sir do we in example two ( chapter 21)assume that the new project is fully equity financed.what would happen if the new project is both equity and debt finance? will we still assume Bd=0 in that case. I am bit confused . Please help

In example 2 we are not assuming that the project is 100% equity financed. We assume it is financed in the same way that the company is currently financed (which is a gearing ratio of 0.4).

The question (as in exam questions) asks for the project specific cost of equity, i.e. the cost of the equity being used to part-finance the project.

Since that requires to ungear and then regear the beta of the similar company, we need to use the asset beta formula and whenever we use the asset beta formula in the exam, we assume that the debt beta is zero.

thanks you sir for your reply. Sir if in this question future cash flows were given and we need to discount it to its present value to determine whether project is worth doing then we can’t discount it at the cost of equity as there is also a gearing ( debt finance) in new project. What discount rate would we use in that case ?

You would either calculate a WACC using the project specific cost of equity and the cost of debt, weighted as per the gearing in the project, or – more likely – by calculating the adjusted present value (which again, is a P4 topic – not an F9 topic).

sir as you said in the lecture that Be is the measures the riskiness of share/equity beta and is due to the riskiness of the nature (Ba) of the business and due to the level of gearing. you said that we have to assume the riskiness due to debt is zero (ie Bd=0 ) . When we are considering that Be ( equity B) is due to gearing and and riskiness of nature of bussiness then why should we assume Bd=0 ?

The two things are independent of each other.
The more debt there in a company then the more risky the shares are (because of the fixed interest payable) – this is explained with an example on one of the earlier lectures, and has nothing to do with how risky the debt is.

Separately, in real life debt does have risk and will therefore have a beta (although small risk and therefore a small beta). It is just that in the exam, when using the asset beta formula we assume that debt is risk free and therefore has a beta of 0.

Sir,in the above lecture while explaining example 4 you stated that T PLC is fully equity financed but it is not relevant. Why is that?capm only measures systematic risks so surely it can’t include risks of a particular business due to its gearing..so while using capm formula we have to assume that the particular investment is fully equity financed.sir please clarify it..I’m bit confused

The beta of a share depends on both the risk of the business and the gearing risk. The higher the gearing, the more risky the share, and therefore the higher will be the beta of the share. The CAPM formula certainly does not assume that an investment is fully equity financed.

Well if the CAPM model does not assume that it,s all equity financed then please tell me how come in this question we ignored the debt beta?

A share in MS Co has an equity beta of 1.3. MS Co’s debt beta is 0.1. It has a gearing ratio of 20% (debt:equity). The market premium is 8% and the risk free rate is 3%. MS Co pays 30% corporation tax.
What is the cost of equity for MS Co?

The equity beta measure the risk of the share. It is the risk of the share – i.e. the equity beta – that determines the return that shareholders require, and hence the cost of equity. You are given the equity beta in the question.

(Please ask about specific questions in the Ask the Tutor Forum and not as a comment on a lecture.)

You told us several ways to calculate the cost of equity depending on the info given such as using the beta or using the dividend growth model. Is there any other way that the examiner can ask us to calculate the cost of equity or the shareholders required rate of return which I think is one and the same thing.

And whatever the cost of equity through either method, we just discount it at that rate, right.

There are no other ways of calculating the cost of equity.

With regard to your last sentence, I don’t know what you are referring to – discount what at that rate?? If you mean discount the expected dividends at that rate to get the market value, then the answer is yes.

hello sir,
would u mind to explain me again , what is market return means, ? is it something like , for the same share market gives a avg return of x%?
thanks

Dear John,
Its quite easy and logical. what is project-specific and marginal cost of capital…and if waac is not suitable for unsimilar business risk situation, then is it same to simple interest rate( cost of cap.)?

I am not completely sure what you mean (‘is it same to simple interest rate….’).

Usually we discount at the WACC, and this assumes that the gearing is remaining unchanged and that the business risk is remaining unchanged.

You can be asked to deal with the situation we the business risk is changing. To do this we need to obtain an asset beta for the project (which is the measure of the riskiness); then we have to calculate an equity beta from the asset beta (using the existing gearing of the company); then we use that to calculate a cost of equity for the project (the project-specific cost of equity).
Usually that is all that is required in the exam. However, if you were asked for it, in order to find an appraisal rate we then calculate a WACC for the project in the normal way, but using the project specific cost of equity (already calculated) in the calculation.

Thanks John. Enjoyed the lecture. Though I think the lecture title is a little misplaced. It doesnt combine MM and CAPM. The example done is in the CAPM chapter

Dear John,
I got kind of confused. Why is that cost of equity is Re? When we say investing in project, do we mean investing in other companies shares? And can you please explain what you mean by calculating an asset beta from an equity beta (and vice versa). Thanks a lot.

The cost of equity is whatever rate of return shareholders are requiring.

If shareholders want a return of (say) 10%, then the company has to be able to pay them 10%. When appraising a project we need to make sure that the project gives enough to pay the lenders and that is what the WACC is (and the calculation of it take the cost of equity and the cost of debt into account).

Beta is a measure of risk. The reason shares are risky is partly because of the nature of the business – some businesses are more risky than others – and partly because of the gearing (gearing makes shares more risky).

The equity beta measures the risk of a share (and therefore includes the effect of any gearing). The asset beta measures the risk of the business itself (excluding any gearing). We can get from one to the other using the formula on the formula sheet.

Thank you, I got what you are saying, but there is one more thing I would like to clarify. So when calculating return from CAPM model, we get a return which takes into account the riskiness of the project. Shall we get the same when using DVM, because as I understand, it assumes return will remain unchanged for future projects.

In a perfect world, DVM and CAPM should give the same required return (therefore the same cost of equity).

However they are unlikely to be the same in practice because of the assumptions and estimates that are needed in both the calculations.

CAPM is regarded as giving a better estimate of the cost of equity than DVM.
(In the exam you obviously use whichever method is required in the question).

Hi Stacy, , you get $1.39 because of in your workings you wrote 14.8-0.03 . it should be 0.148- 0.03 instead. try it , you will realize it, common mistake when we do it fast…

@staceyhowe, Hi Stacy, , you get $1.39 because of in your workings you wrote 14.8-0.03 . it should be 0.148- 0.03 instead. try it , you will realize it, common mistake when we do it fast…

Here return to shareholders, E(ri) is equal to cost of capital of the new project.

I thought the question was asking for the minimum cash flow requirement in perpetuity for the project to be acceptable, in that case nearly 13,000 will give npv is zero, where project can be accepted.On that basis, 15,000 pa for ever is acceptable straight away as it gives a NPV of 15385 positive.

A nice example to integrate investment appraisal and CAPM.

Ajibola says

In a geared company, we remove their equity beta and incorporate the asset beta to determine the project-specific cost of equity in our company.

If we are given a scenario where the new company’s business that we are trying to imitate is financed purely by equity, obviously their beta would only reflect the unsystematic risks of shares. How do we calculate the risks of their business asset beta only in order to determine the project specific cost of equity?

John Moffat says

If there is all equity finance, then the equity beta is the same as the asset beta. The only reason that the equity beta is ever more than the asset beta is because of the extra risk created by the gearing.

ABC says

Sir do we in example two ( chapter 21)assume that the new project is fully equity financed.what would happen if the new project is both equity and debt finance? will we still assume Bd=0 in that case. I am bit confused . Please help

John Moffat says

In example 2 we are not assuming that the project is 100% equity financed. We assume it is financed in the same way that the company is currently financed (which is a gearing ratio of 0.4).

The question (as in exam questions) asks for the project specific cost of equity, i.e. the cost of the equity being used to part-finance the project.

Since that requires to ungear and then regear the beta of the similar company, we need to use the asset beta formula and whenever we use the asset beta formula in the exam, we assume that the debt beta is zero.

ABC says

thanks you sir for your reply. Sir if in this question future cash flows were given and we need to discount it to its present value to determine whether project is worth doing then we can’t discount it at the cost of equity as there is also a gearing ( debt finance) in new project. What discount rate would we use in that case ?

John Moffat says

This will not be asked in F9 – only in P4.

You would either calculate a WACC using the project specific cost of equity and the cost of debt, weighted as per the gearing in the project, or – more likely – by calculating the adjusted present value (which again, is a P4 topic – not an F9 topic).

ABC says

sir as you said in the lecture that Be is the measures the riskiness of share/equity beta and is due to the riskiness of the nature (Ba) of the business and due to the level of gearing. you said that we have to assume the riskiness due to debt is zero (ie Bd=0 ) . When we are considering that Be ( equity B) is due to gearing and and riskiness of nature of bussiness then why should we assume Bd=0 ?

John Moffat says

The two things are independent of each other.

The more debt there in a company then the more risky the shares are (because of the fixed interest payable) – this is explained with an example on one of the earlier lectures, and has nothing to do with how risky the debt is.

Separately, in real life debt does have risk and will therefore have a beta (although small risk and therefore a small beta). It is just that in the exam, when using the asset beta formula we assume that debt is risk free and therefore has a beta of 0.

Ketty says

Very well explained! Thank you 🙂

John Moffat says

You are welcome 🙂

noor mohamed hassan says

superb. thank you

John Moffat says

Thank you for the comment 🙂

Tharuka says

Sir,in the above lecture while explaining example 4 you stated that T PLC is fully equity financed but it is not relevant. Why is that?capm only measures systematic risks so surely it can’t include risks of a particular business due to its gearing..so while using capm formula we have to assume that the particular investment is fully equity financed.sir please clarify it..I’m bit confused

John Moffat says

The beta of a share depends on both the risk of the business and the gearing risk. The higher the gearing, the more risky the share, and therefore the higher will be the beta of the share. The CAPM formula certainly does not assume that an investment is fully equity financed.

Tharuka says

Thank you sir..

John Moffat says

You are welcome 🙂

Tahir says

Well if the CAPM model does not assume that it,s all equity financed then please tell me how come in this question we ignored the debt beta?

A share in MS Co has an equity beta of 1.3. MS Co’s debt beta is 0.1. It has a gearing ratio of 20% (debt:equity). The market premium is 8% and the risk free rate is 3%. MS Co pays 30% corporation tax.

What is the cost of equity for MS Co?

John Moffat says

The equity beta measure the risk of the share. It is the risk of the share – i.e. the equity beta – that determines the return that shareholders require, and hence the cost of equity. You are given the equity beta in the question.

(Please ask about specific questions in the Ask the Tutor Forum and not as a comment on a lecture.)

Arun says

Hi John,

You told us several ways to calculate the cost of equity depending on the info given such as using the beta or using the dividend growth model. Is there any other way that the examiner can ask us to calculate the cost of equity or the shareholders required rate of return which I think is one and the same thing.

And whatever the cost of equity through either method, we just discount it at that rate, right.

Thanks.

John Moffat says

There are no other ways of calculating the cost of equity.

With regard to your last sentence, I don’t know what you are referring to – discount what at that rate?? If you mean discount the expected dividends at that rate to get the market value, then the answer is yes.

arman90fy says

hello sir,

would u mind to explain me again , what is market return means, ? is it something like , for the same share market gives a avg return of x%?

thanks

John Moffat says

It is the overall return on the stock exchange – the average of the returns of all the shares on the stock exchange.

arman90fy says

got it. thank you sir

padmanaveen says

hello sir,

whatever video i open it repeats the video of Interest rate risk part a…

kindly help

Thanks

opentuition_team says

try another browser – your internet provider it seems might be blocking the streams. if all fails, use Tor Browser

acca2050 says

Dear John,

Its quite easy and logical. what is project-specific and marginal cost of capital…and if waac is not suitable for unsimilar business risk situation, then is it same to simple interest rate( cost of cap.)?

John Moffat says

I am not completely sure what you mean (‘is it same to simple interest rate….’).

Usually we discount at the WACC, and this assumes that the gearing is remaining unchanged and that the business risk is remaining unchanged.

You can be asked to deal with the situation we the business risk is changing. To do this we need to obtain an asset beta for the project (which is the measure of the riskiness); then we have to calculate an equity beta from the asset beta (using the existing gearing of the company); then we use that to calculate a cost of equity for the project (the project-specific cost of equity).

Usually that is all that is required in the exam. However, if you were asked for it, in order to find an appraisal rate we then calculate a WACC for the project in the normal way, but using the project specific cost of equity (already calculated) in the calculation.

Ahmed says

Thanks John. Enjoyed the lecture. Though I think the lecture title is a little misplaced. It doesnt combine MM and CAPM. The example done is in the CAPM chapter

John Moffat says

No – the title is correct.

Calculating an asset beta from an equity beta (and vice versa) is actually Modigliani and Miller.

Lilit says

Dear John,

I got kind of confused. Why is that cost of equity is Re? When we say investing in project, do we mean investing in other companies shares? And can you please explain what you mean by calculating an asset beta from an equity beta (and vice versa). Thanks a lot.

John Moffat says

The cost of equity is whatever rate of return shareholders are requiring.

If shareholders want a return of (say) 10%, then the company has to be able to pay them 10%. When appraising a project we need to make sure that the project gives enough to pay the lenders and that is what the WACC is (and the calculation of it take the cost of equity and the cost of debt into account).

Beta is a measure of risk. The reason shares are risky is partly because of the nature of the business – some businesses are more risky than others – and partly because of the gearing (gearing makes shares more risky).

The equity beta measures the risk of a share (and therefore includes the effect of any gearing). The asset beta measures the risk of the business itself (excluding any gearing). We can get from one to the other using the formula on the formula sheet.

Lilit says

Thank you, I got what you are saying, but there is one more thing I would like to clarify. So when calculating return from CAPM model, we get a return which takes into account the riskiness of the project. Shall we get the same when using DVM, because as I understand, it assumes return will remain unchanged for future projects.

John Moffat says

In a perfect world, DVM and CAPM should give the same required return (therefore the same cost of equity).

However they are unlikely to be the same in practice because of the assumptions and estimates that are needed in both the calculations.

CAPM is regarded as giving a better estimate of the cost of equity than DVM.

(In the exam you obviously use whichever method is required in the question).

ahmed says

Hi John, In your 1st example I still don’t get $1.75. I always get $1.39 even if i do 0.148-0.03

John Moffat says

But the first example in this lecture is calculating the beta of the share, so I don’t really know where you are getting these figures from!

harryamoatey says

plz the video does not function when using mozilla, could u check it plz.

John Moffat says

The video is working fine – check the technical support page. The link is above.

harryamoatey says

plz JOHN, am sorry for disturbing u, the problem was with my player, i have updated it and the video is working fine.

Matseliso says

can I download these lectures

opentuition_team says

lectures are on line only

Ken says

very nice.thanks again

jonathan83 says

Hi Stacy, , you get $1.39 because of in your workings you wrote 14.8-0.03 . it should be 0.148- 0.03 instead. try it , you will realize it, common mistake when we do it fast…

cheerios

staceyhowe says

In your 1st example I can not get $1.75 no matter what I do all I keep getting $1.39. What am I doing wrong?

jonathan83 says

@staceyhowe, Hi Stacy, , you get $1.39 because of in your workings you wrote 14.8-0.03 . it should be 0.148- 0.03 instead. try it , you will realize it, common mistake when we do it fast…

Ken says

@staceyhowe, hello, how was your exam?

funlover says

Here return to shareholders, E(ri) is equal to cost of capital of the new project.

I thought the question was asking for the minimum cash flow requirement in perpetuity for the project to be acceptable, in that case nearly 13,000 will give npv is zero, where project can be accepted.On that basis, 15,000 pa for ever is acceptable straight away as it gives a NPV of 15385 positive.

A nice example to integrate investment appraisal and CAPM.