CAPM explains why the cost of equity is what it is. IRR is of no relevance in calculating the cost of equity – the cost of redeemable debt is what is calculated as the IRR.

In the lecture you used 100 equity +40 debt =140 for P and 100 equity +20debt =120 for Q. You found P to be more risky with P Asset Beta=1.4 and Q Asset Beta=1.3

I used 60+40=100 for P and 80+20=100 for Q. I found Q to be more risky. P Asset Beta=1.23 and Q Asset Beta=1.27

Hello sir, Could you please explain what you mean when at the end of the lecture you say regarding eg 11- if we are changing gearing and the level of risk is changing,we cant use weighted average. I dont understand why not because from what i understood in the previous lecture is that when we combine investments, the overall beta will be the weighted average of the individual betas. I must be missing sth out here..so will be grateful for your clarification. Thanks

The fact that the overall beta is the weighted average of the individual betas is of no relevance to this. If the gearing changes then the WACC will change (that is M&M) and if the overall level of risk changes then so will the WACC. It may help you to watch the Paper F9 lecture on ‘when and when not to use the WACC’.

Respected sir, Borrowing 950 Share capita 500 Reserves 400 Company want to raise finance 250 acquired Comapny value 270 What is gearing after acquisition?

The beta of a share measures the risk of a share and part of the risk is due to the gearing. If we want to measure the risk of the actual business then we need to remove the affect of the gearing and calculate what the beta would be without gearing.

This is all explained in the lectures on CAPM. (I assume that you have watched all the earlier ones?) If you still have problems with the idea then watch also the Paper F9 lectures on CAPM (because this is revision of F9)

do I understand correctly that greater gearing increases systematic risk and therefore beta is increasing as well?

So greater the gearing >>>> greater systematic risk of a stock >>>> greater Beta >>>>>> greater Ke >>>>>> Greater WACC >>>>>> lower value of a company?

Is It also depends when WACC will increase due to gaering in accordance with MM and traditional theory as there are also capital structure issues?

Increased gearing implies increased Vd >>>>>>>> Vd makes greater Beta Equity >>>>>>>> Greater Beta Equity makes greater WACC >>>>>>> once WACC is greater Ve is lower (in accourdance with say discounted FCF model)

My question is: Once Ve became lower (and gearing has changed again) should we recalculate Beta Equity again? If it is the case it is becoming endless circle… How should we deal with that issue?

More gearing increases the beta of the share and therefore increases the cost of equity.

However this does not mean that the WACC will increase because more gearing also means more debt and the cost of debt is lower than the cost of equity. As you will remember from earlier lectures, according to M&M with tax, the WACC will fall with higher gearing.

If the company is unquoted then certainly we do not know Ve. In an exam you will either have to be given a value or given the gearing ratio. (We can however find the asset beta by taking a similar quoted company and angering their equity beta using their gearing)

Beta = Standard deviation of systematic risk of a company/ Standard deviation of systematic risk of a Market.

We assume that systematic risk of a Market is fixed. So beta can be greater only in case if systematic risk of a company is greater. Once gearing increases Beta does it imply increasing in systematic risk? Otherwise how can we make beta greater due to gearing in accordance with above formula?

Just a bit confused. “published betas are betas of a share”. Does betas of a share mean Equity beta?

Equity betas are betas showing the gearing effect along with the systematic risk of a share. And to show the business risk only, which is systematic risk, the equity beta needs to be ungeared ( which is the asset beta). Am I right?

We ungear a similar company to find the riskiness of the business and therefore the project (the asset beta).

To appraise the project we also need to take into account the gearing of the project (because the gearing in the project will make the equity more risky), so we need to regear the beta to get the equity beta.

If it is a normal NPV question, then we need to discount at the WACC. We usually assume that the gearing of the project will be the same as that currently existing in the company, so you regear the beta to get the equity beta. Use this to get the cost of equity. Then calculate a WACC for the project in the normal way.

If you are being asked for the APV, then regearing is not relevant (because the base case NPV assumes all equity and we are dealing with the gearing separately).

ziyapapa says

so, in essence, CAPM replaces IRR in the WACC?

John Moffat says

Not at all!!

CAPM explains why the cost of equity is what it is. IRR is of no relevance in calculating the cost of equity – the cost of redeemable debt is what is calculated as the IRR.

Vineeth says

In the lecture you used 100 equity +40 debt =140 for P and 100 equity +20debt =120 for Q. You found P to be more risky with P Asset Beta=1.4 and Q Asset Beta=1.3

I used 60+40=100 for P and 80+20=100 for Q.

I found Q to be more risky. P Asset Beta=1.23 and Q Asset Beta=1.27

John Moffat says

But you are wrong.

The question specifically defines the gearing ratio as being the ratio of debt to equity.

Your figures give a ratio of 40/60, which is not equal to 0.4 !!

sayma says

Hello sir,

Could you please explain what you mean when at the end of the lecture you say regarding eg 11- if we are changing gearing and the level of risk is changing,we cant use weighted average. I dont understand why not because from what i understood in the previous lecture is that when we combine investments, the overall beta will be the weighted average of the individual betas. I must be missing sth out here..so will be grateful for your clarification. Thanks

John Moffat says

The fact that the overall beta is the weighted average of the individual betas is of no relevance to this.

If the gearing changes then the WACC will change (that is M&M) and if the overall level of risk changes then so will the WACC.

It may help you to watch the Paper F9 lecture on ‘when and when not to use the WACC’.

sajiiiii says

Respected sir,

Borrowing 950

Share capita 500

Reserves 400

Company want to raise finance 250

acquired Comapny value 270

What is gearing after acquisition?

John Moffat says

You must ask this sort of question in the Ask the Tutor Forum – not as a comment on a lectures.

(and what you have asked is not about ungearing beta’s and is not a complete question anyway)

Sabrina says

Why do you upgear and why?

John Moffat says

We don’t “upgear”!

The beta of a share measures the risk of a share and part of the risk is due to the gearing. If we want to measure the risk of the actual business then we need to remove the affect of the gearing and calculate what the beta would be without gearing.

This is all explained in the lectures on CAPM. (I assume that you have watched all the earlier ones?)

If you still have problems with the idea then watch also the Paper F9 lectures on CAPM (because this is revision of F9)

petrochina says

Sir,

do I understand correctly that greater gearing increases systematic risk and therefore beta is increasing as well?

So greater the gearing >>>> greater systematic risk of a stock >>>> greater Beta >>>>>> greater Ke >>>>>> Greater WACC >>>>>> lower value of a company?

Is It also depends when WACC will increase due to gaering in accordance with MM and traditional theory as there are also capital structure issues?

petrochina says

One more question Sir,

Increased gearing implies increased Vd >>>>>>>> Vd makes greater Beta Equity >>>>>>>> Greater Beta Equity makes greater WACC >>>>>>> once WACC is greater Ve is lower (in accourdance with say discounted FCF model)

My question is:

Once Ve became lower (and gearing has changed again) should we recalculate Beta Equity again? If it is the case it is becoming endless circle… How should we deal with that issue?

petrochina says

and where do we get Ve initially if the company is unquoted?

Sorry that I ask a lot of question if they are irrelevant or out of P4 scope may be there is no need to answer them…

John Moffat says

More gearing increases the beta of the share and therefore increases the cost of equity.

However this does not mean that the WACC will increase because more gearing also means more debt and the cost of debt is lower than the cost of equity. As you will remember from earlier lectures, according to M&M with tax, the WACC will fall with higher gearing.

John Moffat says

If the company is unquoted then certainly we do not know Ve.

In an exam you will either have to be given a value or given the gearing ratio.

(We can however find the asset beta by taking a similar quoted company and angering their equity beta using their gearing)

petrochina says

Thank you sir, now rewatching F9 lecture relating to MM and capital structure.

For those who not sure regarding effect of gearing I recommend to watch this lecture regarding MM and Traditional gearing theory first…

https://opentuition.com/acca/f9/the-cost-of-capital-the-effect-of-changes-in-gearing/

but anyway I want to confirm my understanding:

Beta = Standard deviation of systematic risk of a company/ Standard deviation of systematic risk of a Market.

We assume that systematic risk of a Market is fixed. So beta can be greater only in case if systematic risk of a company is greater. Once gearing increases Beta does it imply increasing in systematic risk? Otherwise how can we make beta greater due to gearing in accordance with above formula?

John Moffat says

Gearing increases all the risk in a share, but it is only the systematic risk that we are concerned about.

petrochina says

Thank you!

anonymous says

Hi Sir

Just a bit confused. “published betas are betas of a share”. Does betas of a share mean Equity beta?

Equity betas are betas showing the gearing effect along with the systematic risk of a share. And to show the business risk only, which is systematic risk, the equity beta needs to be ungeared ( which is the asset beta). Am I right?

John Moffat says

Yes – the betas of shares are the equity betas.

And yes about the gearing also 馃檪

anonymous says

Thank you!! 馃檪

anonymous says

And is it ok to ask qns relating to the lectures right here or should it be asked inn ask the tutor forum?

John Moffat says

If the question relates directly to the lecture, then here is OK.

Better though is Ask the Tutor 馃檪

foladun says

Great great thanks!. Makes sense after reading the lines carefully.lol

foladun says

Hi,

Helpful note!

Just thinking that at what point do we now need to regear when appraising a project as example 11 only stopped at re-gearing

foladun says

sorry i mean’t example 11 stopped at un-gearing.

John Moffat says

If the examiner asks for a project specify cost of equity, he expects you to regear the beta and then calculate the cost of equity

foladun says

Ok thanks……….but re-gear using the company’s capital structure / the project intended capital structure?

Also,this lecture was able to break down the essence of ungearing.please can you help me out with the simplistic reason for re-gearing?

John Moffat says

We ungear a similar company to find the riskiness of the business and therefore the project (the asset beta).

To appraise the project we also need to take into account the gearing of the project (because the gearing in the project will make the equity more risky), so we need to regear the beta to get the equity beta.

If it is a normal NPV question, then we need to discount at the WACC. We usually assume that the gearing of the project will be the same as that currently existing in the company, so you regear the beta to get the equity beta. Use this to get the cost of equity. Then calculate a WACC for the project in the normal way.

If you are being asked for the APV, then regearing is not relevant (because the base case NPV assumes all equity and we are dealing with the gearing separately).

I hope that all makes sense 馃檪

prakashshrestha says

v gd

bedus says

very helpful

tonyhoneybird says

The speed of current format is not as good as previous format. What should I do if I prefer to use previous format?

admin says

new format is actually more reliable, and you can watch it on your mobile.

what is your problem?

hssniqbl says

HAHA HAHA! U got told!!!!

slobodanm says

very good

kerr says

Going good. I am just refreshing my memory and I love this area.

alsun says

when appraising project when do we:

Ungeared and why?

ungeared and regeared and why ?