FM BPP P&R Kit Q200 Page 190

Hi John,

Can you please help me with the solution to this question, as I am unsure how it was calculated.

Q
Shyma Co is a company that manufactures ships. It has an equity beta of 1.6 and a debt:equity ratio of 1:3. It is considering a new project to manufacture farm vehicles. Trant Co is a manufacturer of farm vehicles and has an asset beta of 1:1 and a debt:equity ratio of 2:3. The risk free rate of return is 5%, the market risk premium is 3% and the corporation tax rate is 40%

Using CAPM what would be the suitable cost of equity for Shyma Co to use in its appraisal of the farm machinery project (to one decimal place)?

A
The correct answer is 9.0%
To reflect the business risk of the new investment, Shyma Cos beta of 1.6 should be ignored and instead the proxy beta of 1.1 should be used. This proxy beta is already an asset beta so does not need to be ungeared.

The asset beta does need to be regeared for Shyma Cos debt:equity ratio

Equity beta = 1.1 * (3+1(1-0.4)/3 = 1.32

Using CAPM Ke = 5+1.32*3 = 8.96% = 9.0% to 1 decimal place

I understand the solution up to the re gearing of the proxy asset beta. I get 0.88 for this calculation whereas the above solution gives 1.32

Can you tell me if the above 1.32 is incorrect or am I missing something?

Thanks a mill
Eliza