ExpertHard2 marksMultiple Choice
ACCA · Question 12 · Estimating the Cost of Capital
Section A
Alpha Co is an all-equity financed company with an equity beta of 1.2. It plans to change its capital structure to 30% debt and 70% equity. The risk-free rate is 4% and the market risk premium is 6%. Corporation tax is 20%.
Assuming debt is risk-free (debt beta = 0), what will be Alpha Co's new equity beta after the gearing change?
Section A
Alpha Co is an all-equity financed company with an equity beta of 1.2. It plans to change its capital structure to 30% debt and 70% equity. The risk-free rate is 4% and the market risk premium is 6%. Corporation tax is 20%.
Assuming debt is risk-free (debt beta = 0), what will be Alpha Co's new equity beta after the gearing change?
Answer options:
A.
1.20
B.
1.54
C.
1.61
D.
1.71
How to approach this question
Since the company is currently all-equity, its current equity beta IS its asset beta. Use the asset beta formula to re-gear the beta to the new capital structure: Be = Ba * [1 + (Vd/Ve)*(1-T)].
Full Answer
C.1.61✓ Correct
1. Because Alpha Co is currently all-equity, its Asset Beta (Ba) equals its Equity Beta (Be) = 1.2.
2. We need to re-gear this beta to reflect the new financial risk. The formula is: Be = Ba * [1 + (Vd/Ve) * (1 - t)].
3. Vd = 30, Ve = 70. Tax (t) = 0.20.
4. Be = 1.2 * [1 + (30/70) * (1 - 0.20)]
5. Be = 1.2 * [1 + (0.42857 * 0.8)]
6. Be = 1.2 * [1 + 0.34286] = 1.2 * 1.34286 = 1.611 (rounds to 1.61).
Common mistakes
Using 30/100 for Vd/Ve instead of 30/70. Vd is 30, Ve is 70.
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