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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!!!!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?- Topics: 1
- Replies: 87
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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 => CAPMProcedure:
(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 WACCHope this helps,
Kevin Kelly
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