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Chapter 10

6.5 Application to business valuation

There are two ways in which the gearing/degearing formulae above can
be used to derive a cost of equity and/or a WACC that can be used in
business valuation.

Both methods start from the assumption that you have been given an
equity beta for a proxy company.

Method 1 Method 2

 Use the formula to derive the  Use the formula to derive the

proxy entity's ungeared beta proxy entity's ungeared beta
factor. factor.

 Assume that this beta factor also  Use CAPM to find an ‘ungeared

reflects the business risk of the cost of equity’ (k eu) for the proxy
entity being valued, so regear entity.

this ungeared beta to reflect the
capital structure of the entity  On the assumption that this k eu
being valued. is also a measure of the
ungeared cost of equity of the
 Then use CAPM to derive a cost entity being valued (same
of equity for the entity being business risk), use M & M's
valued. WACC formula to calculate the
WACC of the entity being
 (If necessary) Use this k e in the valued.
standard WACC formula to find
the entity's WACC.

(Note: Method 2 can only be used to calculate WACC, whereas Method 1 derives
both cost of equity and WACC.) Both methods will now be illustrated, to show that
they give the same answer for WACC.

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