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for the last example we assumed the investing company’s gearing to be the same as the projects gearing. Why do we make this confusing assumption? and if the project has a different gearing wont we still be able to calculate the cost of equity? and then the wacc
Why is it a confusing assumption? It is assuming that the company maintains its current level of gearing (which would be sensible).
If the gearing is different we can calculate the project specific cost of equity (as explained in my lectures), but in Paper FM you will not be asked to calculated a WACC for the project in this case.
Sir for the example (from the lecture) why do we assume that the gearing of the project will be as same as company even if the project has different gearing wouldn’t we still be able to calculate the cost of equity? This is what I mean.
X plc is an oil company with a gearing ratio (debt to equity) of 0.4. Shares in X plc have a à of 1.48.
They are considering investing in a new operation to build ships, and have found a quoted shipbuilding company – Y plc. Y plc has a gearing ratio (debt to equity) of 0.2, and shares in Y plc have a à of 1.8.
The market return is 18% and the risk free rate is 8%. Corporation tax is 25%
Calculate the project specific cost of equity.
Because we assume that X is maintaining its current level of gearing.
but Sir doesn’t the gearing should be in relation to project and not the company who is planing to under take the project. and even if X mantained the same level of gearing wouldn’t it imply that they have also raised debt finance and capm woud not not measure cost of equity if debt finance is also used for the project
If they were not maintaining the level of gearing then you would have to be told what the gearing was in the project, which this question does not.