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I have no idea on how to do the above mentioned question. What is Ke (i) and what’s the difference between geared and ungeared cost of equity. I mean equity means the opposite of debt so where does gearing come from?
Equity certainly does not mean ‘the opposite of debt’ !!
They are both ways of raising long-term finance.
More gearing creates more risk for the shareholders and therefore the cost of equity for a geared company will be higher than that for an ungeared company.
The first formula on the formula sheet was derived by M&M to be able to calculate the cost of equity in a geared company (Ke) when we know the cost of equity if there is no gearing (Kei). Since we know the cost of equity in the geared company, we can use the formula ‘backwards’ to calculate the cost of equity if there is no gearing.
You can either do it using this formula (as the examiner has done in his answer) or alternatively you can calculate the current equity beta, then use the asset beta formula to arrive at the asset beta (i.e. with no gearing), and use that beta to calculate the cost of equity with no gearing. You would get exactly the same answer.
I do suggest that you watch our free lectures for P4.
Thanks a million John. I am just worried about the time pressure. Only three weeks left to the exam so not sure if I have enough time to watch lectures so I am trying to learn by doing questions due to the time pressure.
Also how could we calculate the equity beta for Mlima Co as we are not given any information to enable us to calculate the equity beta for Mlima Co
Hi,
I’m a little embarrassed to be admitting this but here goes:-
I have look at the solution to this question however when I try to work it through, I can’t rearrange the formula of M&M prop.
Any pointers?
Thanks in advance
Michael:
I guess that you are happy with the figures going into the equation (16.83% etc.).
I find it easier to write everything as a decimal (so 0.1683 rather than 16.83%) otherwise there is a risk of everything going wrong.So….0.1683 = Keu + (0.75 x (Keu – 0.0476) x 1785/1400)
Multiply both sides by 1400:
1400 x 0.1683 = (1400 x Keu) + (0.85 x (Keu – 0.0476) x 1785)Divide both sides by 1785:
1400 x 0.1683 / 1785 = 0.132 = (Keu x 1400/1785) + (0.85 x (Keu – 0.0476)0.132 = 0.7843 Keu + 0.85 Keu – (0.85 x 0.0476)
0.132 + 0.04046 = 0.17246 = 1.6343 Keu
Keu = 0.17246 / 1.6343 = 0.1055 (or 10.55% – say 11%)
(It is a bit different from the answer but I think it is simply due to rounding. If I have made a mistake then sorry 🙂 However, 11% is the same.)
Hope that helps a bit.
Smith: Underwriters charge based on a percentage of the issue price. So if the issue price is lower then the underwriting charge will be lower.
Sir, the examiner has used in MM2 formula actual pretax cost of debt 4,63%. Would it be correct to use a risk free rate instead which amounts to 4% (7-3)?
Yes – that would be accepted. (In a perfect world the two would in theory be the same, but in practice they are not the same)
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