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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.
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 = 1.47Ke = ro + Be (rm-ro)
= 5%+1.47(12%-5%)
=15.29%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))*BeSo Be = 1.586
So cost of equity = 5% + 1.586(12%-5%) = 16.10%
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