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I have done many questions on regearing/ungearing, but I just cannot seem to get my head around this one? It seems no matter how I calculate, I still get the wrong answer? Please advise! 🙁
XYZ plc, a food retailing company, has an equity beta of 0.5 and a gearing level, measured as the market value of debt to equity, of 1:5.
It is trying to decide whether or not to invest in a construction project. It has identified a quoted company that undertakes similar operations to the project in question. The construction company has an equity beta of 1.2 and a gearing level of 1:3.
Corporation tax is 35 per cent.
The equity beta of the quoted construction company is appropriate for establishing a risk-adjusted discount rate for project appraisal, but must first be modified to reflect XYZ plc’s gearing level.
What beta should be used? Answer: 1.12I assume that you found this question in your Revision Kit, in which case surely the answer shows the workings?!!
You need to calculate the asset beta for the contribution company using equity beta of 1.2 and gearing of 1:3. Using the formula, this gives an asset beta of ( 3 / (3 + 0.65) ) 1.2 = 0.9863
Then you need to use the asset beta formula backwards using an asset beta of 0.9863 and gearing of 1.5.
This gives an equity beta of 0.9863 / ( 5 / (5 + 0.65) ) = 1.115(You had better double check my workings, but otherwise I guess the slight difference is just due to rounding)
Tutor John Moffat, thank you for your explanations!
I saw this question from other source also, but your expalnation is more clear.
very appreciate!
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