- This topic has 3 replies, 2 voices, and was last updated 4 years ago by
.
- Posts
This is the answer you gave for calculationg cost of equity using beta in one the ask the tutor platform answers..
The cost of equity for the similar company is 14%.
We know the risk free rate is 4.5% and that the market premium is 4%.
So we can use the normal CAPM formula ‘backwards’ to calculate the equity beta.
14% = 4.5% + Beta x 4%.
The gives an equity beta of 2.375.The gearing is 1:1 (market value of debt to market value of equity)
So we can use the asset beta formula (with equity beta as 2.375, and debt beta as zero as usual). The gives an asset beta of 1.381
If we use this in the normal CAPM formula it gives a cost of equity (with no gearing) as 4.5% + 1.381×4% = 10.02%
My question is how do we assume there is no gearing and use asset beta in the CAPM formula… normally we use equity beta in the CAPM formula ?
If there is no gearing then the equity beta is always equal to the asset beta!!
The only reason that equity betas are ever higher than asset betas is because of the extra risk due to gearing. (You can check this using the formula as well – without gearing the equity beta equals the asset beta).
Fubuki is an APV question and for the APV we always discount at the cost of equity if no gearing.
It depends which CAPM formula you are referring to!!
It is the equity beta that determines the return required by shareholders (and therefore the cost of equity), but as I replied before, if there is no gearing then the equity beta is equal to the asset beta.
It will help you to watch my free lectures on CAPM.
- You must be logged in to reply to this topic.