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Respected Sir,
Here they are using asset beta in the capm formula which I am not able t understand. also, how did they get 75/100 as market values for debt and equity?
Example 1
Leah Co is an all equity financed company which wishes to appraise a project in a new area of
activity. Its existing equity beta is 1.2. The industry average equity beta for the new business area
is 2.0, with an average debt/debt + equity ratio of 25%. The risk-free rate of return is 5% and the
market risk premium is 4%.Answer:
In this case, candidates should ignore the existing equity beta of 1.2 and use the industry average
equity beta of 2.0. This proxy beta needs to be ungeared.
?a = 2 x (75/100) = 1.5
The asset beta does not need to be regarded.
Using CAPM, ke = 5 + 1.5 x 4 = 8.96% = 11%.
In the asset beta formula (when no tax) we need the ratio of the market value of equity to the value of debt+equity.
If debt is 25% of debt+equity, then equity must be 75% of debt+equity.
Uing the asset beta formula (and the reasons for it) is all explained in my free lectures on CAPM.
The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
Thank you, sir.
But sir instead of equity beta why are we using asset beta in the calculation of the cost of equity. I understood the market value part and will also try to watch your lectures on this topic.
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