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Good afternoon John,
Hope this message finds you well.
https://opentuition.com/acca/p4/capital-asset-pricing-model-example-11/
(Chapter 10, example 9/as example 11 on video title)On this lecture, we have 3 ways to raise the new finance.
1. totally by equity
2. 50/50 by equity & debt
3. same gearing ratio as the company X gearing (mother company).How about if we raise all the new fund by debt only? Which beta we need to go for?
Shall we still assume the debt is risk free, while consider tax factor(1-T); therefore using 8% x 0.75= 6% return rate for discounting cash flow of the project?Thanks in advance.
Sorry. Also why we assume the debt investor only would like to go for 8% return as same as risk free rate? Why we don’t assume they go for the market return rate 18%? I understand 8% is the minimum they shall go after, but why they don’t aim for the market rate? The market rate is the benchmark on the market, isn’t it?
Sorry, I am just suddenly confused with the words. (I know this must be a silly question.)
However, could you please kindly advise? Thanks.
If the project were financed entirely from debt we would take an APV approach, which is explained in later chapter.
With regard for the investor accepting the risk free rate, individual investors obviously want as high a return as possible. However the return is determined by investors as a whole, and the return depends on the level of risk – the more risky the investment the higher the return they want, the less risk the investment then the lower return they will accept. That is the whole basis of CAPM.
If the investment has zero risk (as in theory is the case with debt) then they will accept the risk free rate. The market return is the average return from all share investments (which all carry various degrees of risk).
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