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Leah Co is an all equity financed company which wishes to appraise a project in a new area of activity. Its existing equity beta is 1.2. The industry average equity beta for the new business area is 2.0, with an average debt / debt + equity ratio of 25%. The risk-free rate of return is 5% and the market risk premium is 4%.
Ignoring tax and using the capital asset pricing model, calculate a suitable risk-adjusted
cost of equity for the new project.
Solution- In this case, candidates should ignore the existing equity beta of 1.2 and use the industry average equity beta of 2.0. This proxy beta needs to be ungeared.
?a = 2 x (75/100) = 1.5
The asset beta does not need to be regarded.
Using CAPM, ke = 5 + 1.5 x 4 = 8.96% = 11%.
I want to know why we dont do the regearing?
Leah is all equity financed.
We would only need to regear if gearing was being used to finance the project.
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