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The Q says AJT has gearing ratio (debt: (equity+debt)) of 30%, tax at 25%, AJT has an asset beta (ungeared) of 1.2, risk free rate is 5%, and the market return is 12%, ask what’s the cost of equity?
Since the gearing is defined as debt: debt+equity, it means that for every 30 debt there is 70 equity.
So 1.2 = (70 / (70 + (30 x 0.75))) x equity beta
So equity beta = 1.586
So cost of equity = 5% + 1.586 x 7% = 16.1%
(The original answer in the test was wrong – I do apologise. It has now been corrected.)
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