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Hi John,
Please could you explain the following questions:
AJT has a gearing ratio of (debt:(equity + debt)) of 30% ad pays CT of 25%. A share in AJT has a beta of 1.2. The risk free rate is 5% and the market return is 12%. What is the cost of equity?
I get 16.1% by ungearing the beta and using that in CAPM formula, but the answer is 13.4%.The second question is – Apple PLC is thinking of acquiring Orange – an unquoted building company. Orange currently pays a dividend of 0.2 per share and has a dividend cover of 3.2. Apple has found that quoted building companies have an average PE ratio of 9.
what is the most sensible share price Apple should offer based on this information.
I work out eps as 64 cents (0.2×3.2) and using adjusted PE ration of 6 my answer would be 3.84. The answer is 5.76.Any help would be very gratefully received!
thanksQuestion 1:
The beta of a share is always the equity beta, and it is always the equity beta that determines the cost of equity.
You are given the equity beta, and so the cost of equity is:
5% + 1.2 (12% – 5% ) = 13.4%
(The information about the gearing in this question is completely irrelevant.
Question 2:
You have adjusted the PE, but there is no rule about adjusting it.
If Orange was a quoted company then we would offer 9 x 64c = $5.76.
Because it is unquoted you would almost certainly offer less than $5.76, but (again) there is no rule as too how much less.
That is why the question does not ask what should the offer be, but which of the choices would be most sensible. Of the choices available it is $5.76 (Apple may offer less but no way would they offer so little as $0.56 or $1.80 🙂 )
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