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When calculating the ungeared cost of equity for Haizum-the cost of debt in the solution is 4.5%-why is the market risk premium of 4% not added onto the 4.5% government debt yield?
Thanks
Adding the market risk premium to the risk free rate gives the return of the market (i.e. the average return of all shares).
To find the cost of equity for Haizum we would need to know its beta. That is not given, but we do know the geared cost of equity is 14% and therefore to get the ungeared cost of equity we use the M&M Proposition 2 formula.
Hi John,
Thanks for your reply above
Yes that is the formula i was using, i was under the impression that the cost of debt for Haizum would have been the risk free rate plus a premium.
Are we assuming that their cost of debt in the formula is at the risk free rate?Thanks,
PadraigYes, always. When we use the formula the debt is always assumed to be risk free and therefore the return on debt is equal to the risk free rate.
Hi John, I can agree that M&M2 formula we should use Rf for the Kd as one assumption behind the M&M model is all debt is risk free.
But in Tippletine question (Mar/June 2018-Q2), the solution suggests to use pre-tax cost of debt 5.4% instead of risk free rate 2.5% in the M&M2 formula.
Will we be penalized if we use risk free rate in that question?
Please kindly advise.
Thanks.
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