As I understood CAPM can be used as the project discounted rate if project is to be equity financed. And if the project is to be financed both debt and equity than shareholders req.return will need discount rate as WACC, combined with cost of debt. Also I understand from this lecture that CAPM does not assume that the firm is financed entirely from equity. Question is, to use CAPM does specific project needs to be financed by equity while company has gearing in general? Or project can be financed with equity and debt to use CAPM and than first statement is not true? And last, if using WACC can cost of equity be calculated as formula D1/Po + g OR CAPM witch would mean we can use CAPM in WACC? doesn’t matter would we be asked for this in exam – for my information. thank you in advance!

How we calculate the cost of equity depends on the information available in the question. If we are given beta factors then we use CAPM (and it is the equity beta that determines the cost of equity, which may been using the asset beta formula to arrive at it). If, instead, w are given information about future expected dividends then we use the growth formula. (Please ask any more questions about this in the Ask the Tutor Forum rather than as a comment on a lecture 馃檪 )

Firstly, very nice lecture. You always explain it to the core. Secondly, can you please tell me who (author, writer, mathematician) proposed this formula of ungearing?

Thank you for the lecture. I noted that we would assume Debt Beta is risk free in the exam and can you please explain why it would be 0%? Based on examples from previous chapter on CAPM, the risk-free rate is never really 0% but can be 5%, 8% etc. is this different for debt?

You are confusing two things. The risk free rate is the rate of interest on a risk-free investment. Beta measures the level of risk and if something is risk-free then it has a beta of 0.

In theory debt is risk free and therefore has a beta of 0. (In real life, debt is risky but is low risk and therefore has a low beta. When using the asset beta formula we always assume that the beat of debt is zero.

Hi Sir, in the previous chapter beta was defined as a measure of systematic risk in proportion to the market. Here beta is the total risk in proportion to the market. Which is right?

Gearing is not risk that is added on. Gearing multiplies the existing systematic risk (as illustrated in Chapter 13).

JojoBeatsays

Hi sir, for example 2, we are calculating the cost of equity for the project alone and it only has systematic risk since its all equity. So why do we need to take into account the gearing of the company, unless we were going to use the WACC for the project’s appraisal?

The project specific cost of equity is the cost of equity relevant for the project taking into account the gearing existing in the company and the risk of the project. We would use this to calculate a WACC to apply to the project, but that part of not examinable until Paper AFM (and in fact there is a different approach that can be used as you will see when you come to Paper AFM. In Paper FM you can only be asked to calculate the project specific cost of equity as shown in this example.

JojoBeatsays

Hi sir, does it mean that in the last chapter we were using the Asset Beta to calculate the cost of equity considering there was no gearing ?

However I have a little confusion, in example 2 we said the new project will have the same gearing as the firm, but then we used CAPM to get the required return even though CAPM assumes firm is financed entirely from equity. How is it right to use CAPM in this case?

CAPM does. not assume that the firm is financed entirely from equity. CAPM gives us the cost of equity for any equity beta. The equity beta measures the risk of the share – the risk of the business together with the risk due to the fearing.

Hello Sir. Thanks for the amazing lectures. In example 2, we have been asked to calculate only the cost of Equity for the project. In the exams however, can we be asked to calculate the total cost of capital (cost of equity + cost of debt- using WACC) for that specific project? Thank you

Thank you for your comment. In Paper FM you can only be asked to calculate the project specific cost of equity. (Going further is not examined until Paper AFM 馃檪 )

Because it is not relevant and (as is the case in the exam) it is there to check that you know it is not relevant. 1.48 is the beta for shares in an oil company. The investment is building ships which has a different level of risk.

Tena says

As I understood CAPM can be used as the project discounted rate if project is to be equity financed. And if the project is to be financed both debt and equity than shareholders req.return will need discount rate as WACC, combined with cost of debt. Also I understand from this lecture that CAPM does not assume that the firm is financed entirely from equity. Question is, to use CAPM does specific project needs to be financed by equity while company has gearing in general? Or project can be financed with equity and debt to use CAPM and than first statement is not true? And last, if using WACC can cost of equity be calculated as formula D1/Po + g OR CAPM witch would mean we can use CAPM in WACC? doesn’t matter would we be asked for this in exam – for my information. thank you in advance!

John Moffat says

How we calculate the cost of equity depends on the information available in the question. If we are given beta factors then we use CAPM (and it is the equity beta that determines the cost of equity, which may been using the asset beta formula to arrive at it). If, instead, w are given information about future expected dividends then we use the growth formula. (Please ask any more questions about this in the Ask the Tutor Forum rather than as a comment on a lecture 馃檪 )

Kt-lou says

Hi John, why is the Vd when plugged into the formula 40 and not 0.4? In the question is say there is a debt to equity ratio of 0.4

John Moffat says

So either put Ve as 100 and Vd as 40, or if you prefer put Ve as 1 and Vd as 0.4. It doesn’t matter because the result is the same!

Rana Nabeel says

Hey John,

Firstly, very nice lecture. You always explain it to the core. Secondly, can you please tell me who (author, writer, mathematician) proposed this formula of ungearing?

John Moffat says

Thank you for your comment 馃檪

I am not sure who came up with the formula, but it stems directly from Modigliani and Miller.

ty0311 says

Hi Sir,

Thank you for the lecture. I noted that we would assume Debt Beta is risk free in the exam and can you please explain why it would be 0%? Based on examples from previous chapter on CAPM, the risk-free rate is never really 0% but can be 5%, 8% etc. is this different for debt?

Thanks and Regards,

Tim

John Moffat says

You are confusing two things. The risk free rate is the rate of interest on a risk-free investment.

Beta measures the level of risk and if something is risk-free then it has a beta of 0.

In theory debt is risk free and therefore has a beta of 0. (In real life, debt is risky but is low risk and therefore has a low beta. When using the asset beta formula we always assume that the beat of debt is zero.

JojoBeat says

Hi Sir, in the previous chapter beta was defined as a measure of systematic risk in proportion to the market. Here beta is the total risk in proportion to the market. Which is right?

John Moffat says

Nowhere in this chapter is it the total risk in proportion to the market.

JojoBeat says

But isn’t it the systematic risk + gearing risk in this chapter?

John Moffat says

Gearing is not risk that is added on. Gearing multiplies the existing systematic risk (as illustrated in Chapter 13).

JojoBeat says

Hi sir, for example 2, we are calculating the cost of equity for the project alone and it only has systematic risk since its all equity. So why do we need to take into account the gearing of the company, unless we were going to use the WACC for the project’s appraisal?

JojoBeat says

Correction : Unless we were going to use the NEW cost of equity of the company as a whole to calculate the NEW WACC for the project’s appraisal?

John Moffat says

The project specific cost of equity is the cost of equity relevant for the project taking into account the gearing existing in the company and the risk of the project. We would use this to calculate a WACC to apply to the project, but that part of not examinable until Paper AFM (and in fact there is a different approach that can be used as you will see when you come to Paper AFM. In Paper FM you can only be asked to calculate the project specific cost of equity as shown in this example.

JojoBeat says

Hi sir, does it mean that in the last chapter we were using the Asset Beta to calculate the cost of equity considering there was no gearing ?

John Moffat says

The cost of equity is determined by the equity beta. If there is no gearing then the equity beta is equal to the asset beta.

maryam932 says

Hello Sir, thank you for the great explanation.

However I have a little confusion, in example 2 we said the new project will have the same gearing as the firm, but then we used CAPM to get the required return

even though CAPM assumes firm is financed entirely from equity. How is it right to use CAPM in this case?

John Moffat says

CAPM does. not assume that the firm is financed entirely from equity. CAPM gives us the cost of equity for any equity beta. The equity beta measures the risk of the share – the risk of the business together with the risk due to the fearing.

akashnundloll says

Hello Sir. Thanks for the amazing lectures. In example 2, we have been asked to calculate only the cost of Equity for the project. In the exams however, can we be asked to calculate the total cost of capital (cost of equity + cost of debt- using WACC) for that specific project? Thank you

John Moffat says

Thank you for your comment. In Paper FM you can only be asked to calculate the project specific cost of equity. (Going further is not examined until Paper AFM 馃檪 )

nataliemcc says

Dear tutor

In Example 2, there is information about shares in X plc have a B of 1.48, why you haven’t use this figure in the calculation? thx

John Moffat says

Because it is not relevant and (as is the case in the exam) it is there to check that you know it is not relevant. 1.48 is the beta for shares in an oil company. The investment is building ships which has a different level of risk.

Saedeo says

Hi John,

Disregard the above. I realized after I made an error.

rachel13 says

thank you for this lecture, well explained.

John Moffat says

Thank you for your comment 馃檪

zain says

Thank you sir, excellently explained 馃檪

John Moffat says

Thank you for your comment 馃檪

charlamagne says

Am just gonna hope everything discussed in this lecture doesn’t appear in the Exam.

sh4n1 says

thank you very much for your kind effort Mr. Moffat

I’m actually benefitting from it and have understood the topic very well 馃檪

John Moffat says

You are welcome, and thank you for your comment 馃檪

suzcooney says

Excellent explained.

John Moffat says

Thank you for your comment 馃檪

mareez says

As always, very well explained. Thank you!

John Moffat says

Thank you for your comment 馃檪