december 2010 , question 2

We need to know what the cost of equity would be for a project of that level of risk, if it was all equity financed.

They have a company in the same business as the project (Haizum) and we know their cost of equity (14%) but the problem is that they are a geared company. We need to know what it would be if there was no gearing.
To get this they have used the M&M formula on the formula sheet – we ungear Haizums cost of equity using Haizums gearing.

(Alternatively, you could work out the equity beta for Haizum, then ungear it using Haizums gearing to get the asset beta, and then used this beta to get an ungeared cost of equity. You would get exactly the same result.)

The company borrows at 3% above govt debt (which is 4.5%) and so they pay 7.5% interest.
However, 80% of it can come from a subsidised loan which is 2% cheaper at 5.5%.

The total they borrow is 14,488 (the amount needed for the project, grossed up for the issue costs).
They tax tax relief on the interest at 25%.
80% of the borrowing has interest of 5.5% and the other 20% has interest at 7.5%

With regard to the subsidy, the are getting a 2% saving in interest on 80% of the money. However since we have accounting for the tax benefits separately, we don’t want to include them again, so the net subsidy benefit is only 75% of this.

Both the tax relief and the subsidy benefit occur each year for four years, and so they have of course been discounting using the annuity factor.