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I’m really struggling to understand the concept of gearing and ungearing beta factors I’ve listened to the lectures but still not comprehending the principle.
This is an example question I really don’t understand
TR Co has a gearing level of 1:3 debt:equity. TR is considering diversifying into a new market.B Co is already operating in the new market. B Co has an equity beta of 1.05 and a gearing level of 1:4 debt:equity Both companies pay 30% corporation tax
Q. What is the asset beta relevant to TR for the new market
The risk free rate is 4% and the market premium is 4%
Q.What is TR Co’s cost of equity for assessing the decision to diversify into the new market?
This will be the forth time I’ve sat F9 and getting desperate as passed all the other papers first time.
Any help will be gratefully received.
1. TR’s activity will have the same business risk as B. The equity beta of B measures all the risk of the share, including the gearing risk. So to get the business risk you need to use the formula to calculate the asset beta, using the gearing of B because it is the gearing risk of B that is included in the 1.05
2. To get the cost of equity for T to use, you need to get the equity beta (which will be higher than the asset beta because there is gearing in T).
So you take the asset beta already calculated and use the formula ‘backwards’ in order to get the equity beta to apply (using the gearing of T).Then you can use the normal CAPM formula to get the cost of equity: 4% + (equity beta x 4%)
John thank you very much for explaining it is so much clearer now.
This site in invaluable and very much appreciated, having used BPP before i find your explanations so much more comprehensible an far easier to relate to.
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