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Hi John,
I just wanted to be clear about something in this question. Q46 in the BPP Kit.
CAPM was used to find the asset beta of debt. I thought the beta used in CAPM was the equita beta. Am I incorrect in thinking so. Why are they considering the beta determine from rearranging the formula the asset beta.
What I don’t understand is why for Elfix using the same method D1/k-g the answer is considering it an ungeared share price. Is it because we used the asset beta to determine the required return of shareholders.
Also too, I am trying to understang why are we using M & M to deternine the value of te company and to a further extent the value of equity. Couldn’t I just use the after tax interest payments $4.9 (7*.7) when calculating the MV of the debt and add it to the MV of equity to get the total value of the company?
Please help me. I am a little confused.
I will be honest and say that I am not very impressed by this BPP question – they invented it and although some bits are good, I do not think it is realistic for the current examiner. (For one thing, it is very unlikely that the examiner will expect you to consider a debt beta – when using the asset beta formula he will almost certainly expect you to assume a debt beta of zero – i.e. risk free.)
However, to try and answer your questions!
It is the equity beta that determines the return required by shareholders. However, one of the factors that makes the share more risky (and therefore a higher beta) is the level of gearing in the company. The more the gearing, the greater the equity beta.
In this question it is assumed that both companies have the same business risk (i.e. the same risk when the gearing is ignored) and so we need to calculate the asset beta (which measures the risk without any gearing) by using the formula.
Impex then goes on to use M&M to get the market value. However the formula for this is not given in the exam and is unlikely to be required. More sensible would be to work out the equity beta for Elfix (using the gearing in this company) and use this to estimate the market value of the equity (and then add on the market value of the debt).
I hope this is of help (but I do think their answer is all a bit ‘over-the-top’ for the exam!!
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