Gear and re-gear asset Beta

Kkarenlaing15y ago

Hi
I understand this is done in order to incorporate risk from a different type of business, and therefore should take the beta or average beta from a similar business, would have to ungear it to take away it's financial risk (capital structure) and re-gear to our own capital structure.
However, I get very confused with the whole formula and equasion and never know where to start! I also cannot put the reasoning into the equasion to see what it is I am doing (if that makes any sense)
Can you help? Or am I a lost cause!!!!

Kkarenlaing15y ago#1

No need for response to this one - I have worked it out - just going into panic mode a bit and forgetting some stuff.
Has anyone had a chance to look at my query on parity theory?

Former user15y ago#2

Hi Karen,

I'll have a look at your parity query later tonight when I have time and will endeavor to make it as simple as possible for you, sorry about the delay.... please don't start to panic this close to the exam ... take a deep breath ... you are doing fine.

With regard to un-gearing and re-gearing ...

Usually, in the EXAM, the order is DE-GEAR the beta you have been given in the question in order to remove the financial risk element. Now you only have the business risk element left ... this now reflects the risk of the industry that the company operates in, i.e this is the asset or un-geared beta.

If the new project is to be in the SAME industry then all you have to do is RE-GEAR the asset or industry beta calculated above using the debt equity mix of the new project.

But, if the new project is to be in a new industry then your starting point will have to involve finding that particular asset or industry beta - usually by DE-GEARING the EQUITY beta of a similar company within the industry of the new project. Once you have found the new asset or ungeared beta in this way then once again you will have to RE-GEAR it in order to add in the Financial Risk element in accordance with how the new project is to be financed (ie the D/E mix).

Let me summarise the key rules for this part of the syllabus....

What if the conditions for using the WACC as the DF in Investment Appraisal are not met?

Answer: Calculate a New Project specific WACC

(1) Calculate the effect of the Financial Risk (Gearing) change => M&M
(2) Calculate the effect of the Business Risk change => CAPM

Procedure:

(1) Un-Gear company (EQUITY) Beta given in question in order to find the Business Risk element => the Industry Beta of the new Project
(2) Re-Gear Beta to incorporate the Financial Risk of the new Project
(3) Calculate the New Project Specific WACC

Hope this helps,

Kevin Kelly

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