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Is Beta asset also called ungeared cost of equity and is used where capital is wholly financed through equity? In Mlima co.why directors are of the opinion that mlima co’s cost of capital should be based on ziwa co ungeared cost of equity, while mlima co capital is financed by both equity & debt.? please explain this
The asset beta measure the risk of the actual business. The shares are more risky because of the gearing, and so the equity beta measure the risk of the share (and if there is gearing the beta of the share will be higher because the gearing makes the shares more risky).
Part (a) (i) of the question specifically says that the directors are of the opinion that the cost of capital should be based on the unguarded cost of equity (i.e. the cost of equity based on the asset beta (i.e. no gearing)) so for the arithmetic you obviously do what you are told to do 🙂
It is actually sensible, because if the MBO goes ahead, the debt borrowing will all be paid off (per the question) – it will be all equity financed – so there will be no gearing risk. The only risk will be the risk of the business which is what the asset beta measures.
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