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Good Afternoon John,
Hope all is well with you.
Can I please direct your attention to the lecture video I indicated in the title of this question, and can you please refer to minute 11:20 – You mention calculating the cost of equity another way using CAPM. Could you please indicate how this would work? I have tried this calculation and have not gotten anywhere.
I understand the process of using the CAPM formula first to calculate the Beta which is the Equity Beta, which for this question will be the same as the asset beta because there is no gearing present. Then we just add in the capital structure and we have the new Equity Beta which we can insert into CAPM again and get the new cost of equity (with gearing).
The problem is that when I do the first CAPM calculation, we don’t know what the Market Premium is so we can’t calculate the Beta sucessfully.
Hope you can help me with this.
Best,
I wish that I hadn’t mentioned this in the lecture because although it is true, it is time-consuming and therefore is silly in the exam. Most questions give the betas and therefore in that case use the betas. Occasionally you are not given the betas in which case we use the M&M formula.
As you state, this example does not give the risk free rate. However either use a symbol (e.g. R) for the risk free rate, or alternatively invent a risk free rate because ultimately it cancels out in the algebra and so is irrelevant.
However, unless you are great at algebra I really would not waste your time (and certainly not waste the time in the exam if this is relevant 🙂 )
I’m glad you mentioned it because it’s interesting!
However, I will heed your advice and calculate it the normal way and save the algebraic alternative for another time.
Much appreciated John.
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