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Prof,
I did not understand why 4.5% was used as cost of debt to derive the ungeared cost of equity instead of 8.5% (4.5+4).
According to the question, “The five-year government debt-yield is currently estimated at 4.5% and the market risk premium at 4%”
Obviously, the solution in BPP assumes that Haizum Co cost of debt is risk free?
Can I also assume that it is not risk free and use 8.5%?
It is really the fault of the examiner using different symbols in different equations.
Instead of using the MM formula, you could get the same answer using the CAPM formulae (the asset beta formula and the normal CAPM formula for getting the cost of equity) – the formulae are related to each other. (Although in this question it would take longer).
Just as for the asset beta formula we always assume that debt is risk free (so the debt beta is zero), we also for the MM formula always use the risk free rate for Kd.
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