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Hi John
Can you please assist with the following 2 queries that I have on this particular question:
(1) I cannot get round my head of how the Asset Beta of the “Components” part of 1.634 has been derived at.
The company portfolio equity beta is 1.40
The equity beta of the “Other Activities” (excluding the “Components”) are estimated at 75% and is 1.25
I cannot understand the logic and way of how they calculated the 1.634 as the asset beta for the “Components” part.(2) The IRR is calculated as approximately 27.30% – again I worked out 2 guesses 5% and 10% and I got approximately 21.43%…
Can you please help?
Thank you.
1. As I do explain in my lectures (and as is very often needed in the exam), if two streams with different betas are combined then the overall beta will be the weighted average of the two betas.
Here, we need to find the beta of Elfu’s component production. We know the total asset beta is 1.217. We. know the beta of other activities is 1.078 and we know that 75% of Elfu’s equity is in other activities and that therefore 25% is in component production.
Therefore, (0.75 x 1.078) + (0.25 x component beta) = 1.217
Rearranging the equation gives the beta for component production.
2. As always, using two guesses only gives an approximation to the IRR and using different guesses give different answers. You still get full marks provided that your workings are correct and that you are using ‘sensible’ guesses.
If you are taking the exam on computer, then you can use the IRR function in the spreadsheet to get the IRR exactly. If you are taking the paper based exam then you do need two guesses, but given that you are to compare with Process Zeta which has an IRR of 26.6% it would have been sensible to use much higher rates for guesses than 5% and 10% (I would start with 20% and decide from there on a second rate). You would then get much closer to 27.30%.
Thank you John.
Your explanations to my queries are crystal clear.
At least now I have got it clear in my mind, thanks to your valuable advice.
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