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Cost of Equity

Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA FM Exams › Cost of Equity

  • This topic has 2 replies, 3 voices, and was last updated 10 years ago by John Moffat.
Viewing 3 posts - 1 through 3 (of 3 total)
  • Author
    Posts
  • November 14, 2014 at 6:13 pm #210064
    Accountaholic
    Member
    • Topics: 98
    • Replies: 67
    • ☆☆

    Sir,
    Can you please explain this OpenTuition Mock test question?
    AJT Co has gearing ratio (D/E+D) of 30%. Corporation tax is 25%. Asset beta is 1.2
    Risk free return is 5% and Market return is 12%

    What is the cost of equity?

    Many thanks.

    November 14, 2014 at 9:56 pm #210096
    Moses
    Member
    • Topics: 7
    • Replies: 11
    • ☆

    You are given an Asset beta. You need to covert it to the share beta as follows.
    Asset beta = Ve/Ve+Vd(1-T) *Equity beta
    1.2 = 100/(100+30*0.7)*Ke
    Be = 1.47

    Ke = ro + Be (rm-ro)
    = 5%+1.47(12%-5%)
    =15.29%

    November 15, 2014 at 12:29 pm #210186
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 54675
    • ☆☆☆☆☆

    Moses answer is NOT correct for two reasons. He has the gearing wrong, and also has the tax rate wrong.

    Since the gearing is given as debt:debt + equity. It means that if equity + debt is 100, then debt is 30 and therefore equity is 70.

    So….using the asset beta formula,
    1.2 = (70 / (70 + 30*0.75))*Be

    So Be = 1.586

    So cost of equity = 5% + 1.586(12%-5%) = 16.10%

  • Author
    Posts
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