Dec 08 Jupiter Co

I don’t know what you mean by ‘through your suggested answers’!!

The cost of equity is calculated using the CAPM formula on the formula sheet.
You are given the beta of the equity, the market premium, and the risk free rate and the current cost of equity calculation is no problem. (The published betas are always equity betas unless you are specifically told different.)

To calculate the new cost of equity you need to calculate the new equity beta (which will be different because the gearing changes). To do this you need to calculate the asset beta (without the existing gearing) using the asset beta formula from the formula sheet, and then use the formula again to recalculate the equity beta using the new gearing.
(If you are not sure about doing this bit then watch my lecture on CAPM)

With regard to the minimum rate of return needed, the criterion always is to increase shareholders wealth, and so the minimum return is whatever is needed to keep the total shareholders wealth (i.e. the total market value of the equity) the same as it is currently.

To get the current market value of equity we use the dividend growth formula, based on the free cash flow to equity.

When the gearing changes, the shareholders required return increases and therefore the market value of the shares would fall unless we could increase the income (which we can because of the new investment ). So……you can use the dividend growth model backwards – we know what market value we want, we know what the shareholders required return/cost of equity is, and so we can calculate the extra income that is needed to maintain the market value.

Once we have this, then no problem – we know the income we need, we know the investment to be made, and so we can calculate the percentage return needed.

You are welcome 🙂