Quiz question Cost of Equity — OpenTuition Forums

SStefano11y ago

Hi, Would you mind helping me with this question? AJT has a gearing ration debt: (debt+equity) of 30% and pays corporate tax 25% AJT has an asset (ungeared) Beta of 1.2. the risk free is 5% the market return of 12% What is the cost of equity? answer: 16.10% I need to see the calculation as I couldn't calculate the geared beta from above information to apply to the CAPM Thank you in advance, SP

John MoffatTutor11y ago#1

For every 30 debt there is 70 equity. So the asset beta = (70 / (70 + (30 x .75)) x equity beta We know the asset beta is 1.2, so using the above equation gives an equity beta of 1.586 It is the equity beta that determines the shareholders required rate of return and therefore the cost of equity. So the cost of equity = 5% + 1.586 (12% - 5%) = 16.10%

Aalua11y ago#2

Sorry but I still cannot get it! I did exactly the same but (forgive me if its just a calc what I am not doing right) but my equity beta = 0.908 (1.2 x (70/(70+(1-0.25)))) Thanks

John MoffatTutor11y ago#3

You are not reading the formula properly. 1.2 = (70/(70+(1-0.25))) x beta equity So beta equity = 1.2 x (70 + (30 x 0.75)) / 70) = 1.586

Aalua11y ago#4

I beg your pardon! Error in calc as I thought! I understand now, sorry. Many thanks!

John MoffatTutor11y ago#5

No problem :-)