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Mercury is in the business of training and financial services. 1/3 revenues come from financial services.
jupiter is a listed company which does ONLY training.we are given beta and d/e ratio of financial sector
we are given beta and d/e ratio of jupiter
we are given d/e ratio of mercurypart (a) we need to calculate the cost of equity capital and WACC
i calculated the asset beta for the financial sector and then calculated the equity beta for mercury’s financial business
then i calculated the asset beta of jupiter and from that i computed the equity beta for mercury’s training business
then i averaged the 2 equity betas in the proportion of 1/3 and 2/3
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in the kit however, the answer first averaged out the asset betas in 1/3, 2/3 proportions and then computed the equity beta.
i need to understand why is the logic of my answer incorrect
regrds\
Your is incorrect because the level of gearing in the two companies is different, and they impact differently on the equity betas.
Unless the gearing in the two companies is the same, then you must average the asset betas first. (If the gearing were the same, then averaging the equity betas would end up giving the same answer)
am trying to absorb what u wrote. in the mean time, i was doing a separate question and we had to use CAPM to get the cost of equity capital. we were also supposed to list assumptions.
apart from the usual assumptions,
the question specifically said that “debt is not sensitive to market risk, ie. beta of debt=0”in explaining this assumption he writes:
“that since all three companies operate in the same sector, they will have the same asset beta unless their operations are exactly the same, which is very unlikely”
i dont get this. asset betas shd be different for different companies even in the same sector since the gearing is different .. no??
sorry to ask basic questions …
thanks in advance!
my exam is in june.. and i think i might have bitten of more than i can chew!!!!
The asset beta measures the risk of the business, ignoring any financial risk due to gearing.
Therefore businesses in the same sector will have the same asset beta.
The equity betas take into account the financial risk as well as the business risk, and so the equity betas will be different (unless the companies all have the same level of gearing).
(The statement you have quoted does not explain the assumption about the beta of debt being zero – we always assume the beta of debt is zero (unless told different) because in theory debt is risk free. And I don’t know where you got the quotes from – the examiner did not write that in his answer 🙂 )
I don’t know if you have watched the free lectures, but they do explain about the equity and asset betas in detail.)
the quote is from the bpp kit.
i am watching ur fx risk lectures right now. i did revisit ur f9 lectures on gearing/ungearing which made for excellent revision.
and thank u for patiently replying!
I am away at the moment and so do not have access to the question. My flight does not get me home until after midnight.
So please ask again tomorrow and then I will answer you.
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