Page 385 - Microsoft Word - 00 CIMA F1 Prelims STUDENT 2018.docx

Answers

Step 2

A geared/equity beta for Garvey Co is calculated next. As we know, an equity
beta reflects both systematic business risk and systematic financial risk.
Garvey Co's equity beta will reflect the business risk of Garvey Co and Rocket
Co, and the capital structure of Garvey Co (1:2 D:E).

ß = ß + [ß – ß ] [ V D [1 – t] ]= 1.09 + [1.09 – 0] [ 1[1 – 0.30] ] =1.47
eu
eu
eg
d
V E 2
Step 3
This equity beta is then input into the CAPM to give a cost of equity capital for
Garvey Co:

k e = R F + [ R M – R F] ß g

k e = 5% + [12% – 5%] × 1.47 = 15.3%

Step 4

The WACC is now calculated using the standard WACC formula:

WACC = 15.3% × (2/3) + 5% × (1 – 0.30) × (1/3) = 11.4%

Method 2:

Step 1

As above, the existing geared/equity beta of Rocket Co is degeared, to give an
ungeared/asset beta of 1.09.

Step 2

Input this ungeared beta into the CAPM formula to give an ungeared cost of
equity (k eu)

k eu = 5% + [12% – 5%] × 1.09 = 12.6%

Step 3

Use the M & M WACC formula:

k adj = k eu (1 – tL)

= 12.6% (1 – 30% × (1/3)) = 11.4% as before.

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