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In this question, we are undertaking a project that will change our company’s gearing, which means that the financial risk is affected. So in this case, how can we use the existing equity beta to calculate the cost of equity ( to compute NPV), sir?
This is a very old question, and not such a good question.
It depends how you interpret note (iv) in the question. Because you are told the equity beta of the investment, it must mean that in some way or another the gearing has already been taken into account. The Kaplan answer (which is what I assume you are looking at) assumes that it has taken into account the gearing that will be used.
To be fair – there is not much else that they could have assumed.It is always the equity beta that dictates the cost of equity – the problem is which equity beta 🙂
Ahan. But sir, the asset beta has been calculated using the given equity beta and the existing gearing ratio, and not the new gearing. So I was thought that the given equity beta relates to the present gearing.
So if I had used the asset beta attained above to recalculate the equity beta using the new gearing, would that have been right? Or am I missing something here? 🙁
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