Capital structure

This topic has 7 replies, 2 voices, and was last updated 1 year ago by John Moffat.

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April 15, 2021 at 1:02 am #617675
Nercia@1234
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Hello John

If a question asks
Gearing in the industry averages 30% debt and 70% equity

What would be a suitable risk adjusted cost of equity for the new investment if H Co were to be financed in each of the following ways

A. BY 30% Debt and 70% equity
(here Ke the book got 34%)

B. ENTIRELY by equity
(here ke is 28.45%)

C. BY 20% debt and 80% equity
(here ke is 31.75%)

D. By 40 % debt and 60% equity
(here ke is 37%)

My question is how do I pick the suitable answer
April 15, 2021 at 9:30 am #617709
John Moffat
Keymaster
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You have not given enough information to be able to give an answer. I need to know either the average WACC for the industry or the beta for the industry. Otherwise the question is impossible to answer!!

If it is a past exam question or a question from the BPP Revision Kit, then tell me which question and I can then check the whole wording for myself.
April 15, 2021 at 5:14 pm #617771
Nercia@1234
- Topics: 13
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I got it from Kaplan kit test your understanding 6, page 574

Hubbard, an all-equity food manufacturing firm, is about to embark upon
a major diversification in the consumer electronics industry. Its current
equity beta is 1.2, whilst the average equity ß of electronics firms is 1.6.
Gearing in the electronics industry averages 30% debt, 70% equity.
Corporate debt is considered to be risk free.
Rm = 25%, Rf = 10%, corporation tax rate = 30%
What would be a suitable risk-adjusted cost of equity for the new
investment if Hubbard were to be financed in each of the following
ways?
A By 30% debt and 70% equity
B Entirely by equity
C By 20% debt and 80% equity
D By 40% debt and 60% equity
April 16, 2021 at 9:06 am #617849
John Moffat
Keymaster
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I do not have the Kaplan kit – only the BPP Revision Kit.

However, now you have given all the information it is possible to answer the question!!!

In A, the gearing is the same as the industry average, and therefore the equity beta will the same as the average for electronics firms at 1.6, and we can use the normal CAPM formula to calculate the cost of equity.

For A, B, and C we need to use the asset beta formula to calculate the asset beta for electronic firms from the average equity beta.

Once you have got this, then for B when it is entirely equity financed, the equity beta will equal the asset beta.
For C and D you need to use the asset beta formula ‘backwards’ in order to calculate the equity beta for Hubbard.
In all three cases, once you have the relevant equity beta you can use the normal CAPM formula to calculate the cost of equity.

All of this is explained in my free lectures on CAPM, and I really do suggest that you watch them.

The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
April 16, 2021 at 6:58 pm #617913
Nercia@1234
- Topics: 13
- Replies: 16
Okay thank you, ..

However when the questions says

What would be a suitable risk-adjusted cost of equity for the new
investment if Hubbard were to be financed in each of the following
ways

How do I know the suitable risk adjusted cost of equity…
Is it A , B, C or D ..
Or this question is not a multiple choice
April 17, 2021 at 8:14 am #617975
John Moffat
Keymaster
- Topics: 57
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I do not know where you found this question, but it would appear that it is not multiple choice because there is a different answer for each of the four levels of gearing.

(Only a few of the questions in the exam will be multiple choice – there are many different ways questions can be asked in the computer based exam.)
April 18, 2021 at 2:23 am #618053
Nercia@1234
- Topics: 13
- Replies: 16
Okay thank you …
I found it in the Kaplan text
Test your understanding 6
Capital structure…
April 18, 2021 at 6:45 am #618061
John Moffat
Keymaster
- Topics: 57
- Replies: 49603
You are welcome 🙂

I do not have the Kaplan text – only the BPP Revision Kit. If you are watching my free lectures then you do not really need the Study Text because the lectures are a complete free course. It is the Revision Kit that is essential because it is full of past exam and other exam standard questions for practice.
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