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The weighted average cost of capital (WACC)

Use of the formula – degearing and regearing beta factors

Suppose a question tells you that the ABC company has a gearing ratio
(D : E) of 1 : 2, the shares have a beta value of 1.45 (the equity beta),
and the corporate income tax rate is 30%. Then:

Assume debt is risk free and debt beta is zero unless told otherwise.

β a = [2 /2+1(1–0.30)] × 1.45 = 1.074

Four very important implications:

1 A company's equity beta will always be greater than its asset
beta, except

2 if it is all equity financed (and so has no financial risk), when its
equity beta and asset beta will be the same.

3 Companies in the same 'area of business' (i.e. same business
risk) will have the same asset beta, but

4 companies in the same area of business will not have the same
equity beta unless they also happen to have the same capital
structure.

Illustrations and further practice

Now try TYU 1 from Chapter 6

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