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Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA AFM Exams › Example 6 in “The capital asset pricing model (part 2) – ACCA (AFM) lectures”
Replying to:
Nobody is talking about %’s !!!!
“It does not mean 40% is debt and 60% is equity – that would mean a debt to equity ratio os 40/60 which is certainly not 0.4!!
If debt to equity is 0.4, then for every $100 equity the debt is 0.4 x 100 = $40.
Therefore for every $140 total value, the equity is $100 and the debt is $40.”
I’ve been having this confusion too.
But, will the same principle apply if the question says that the debt:equity ratio is 40%?
Found this on a professional website:
Question:
An all-equity company operates in an industry where its beta factor is 0.90. It is
considering whether to invest in a completely different industry.
In this other industry, the average debt/equity ratio is 40% and the average beta
factor is 1.25.
The risk-free rate of return is 4% and the average market return is 7%. If the
company does invest in this other industry, it will remain all-equity financed. The
rate of taxation is 30%. Assume that debt is risk-free
Solution:
The appropriate discount rate should be one that applies to the industry in which
the investment will be made. We know that the ‘geared beta’ in this industry is
1.25, with a debt: equity ratio of 40:60. We can calculate the asset beta for the
industry as:
Ba = 1.25 x 60/[60+40(1-0.3)]
= 0.85
Since the company will be all-equity financed, the cost of equity to apply to the
project is therefore:
4% + 0.85 (7 – 4)% = 6.55%.
Kindly help clarify this sir.
I’ll be so grateful!
I do not know which ‘professional website’ you are referring to, but if you have copied the question accurately then the answer you have typed out is wrong.
The gearing can be given in various ways. If you are told that the debt/equity ratio is 40%, then the debt is 40 for every 100 equity (just as explained in my example).
If on the other hand you are told that the debt equity ratio is 40:60 then this means that the debt is 40 for every 60 equity.