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Capital structure

9.2 Steps to calculate a discount rate for use in investment appraisal

 Find an appropriate asset beta that reflects the correct business risk for the
project – this may involve de-gearing a proxy equity beta using the formula:

V e V d
β a = ––––––––––––– β e + ––––––––––––– β d
V e + V d(1 – T) V e + V d(1 – T)

NB: βd will be assumed to be zero.

V e and V d are the market values of equity and debt of the proxy company

If more than one proxy asset beta is provided, use an average figure

 Re-gear the asset beta to reflect the gearing levels of the company making the
investment (use the same formula but this time to find β e from β a using the
market values of equity and debt for the investing company)

 Use the re-geared beta to find the risk-adjusted cost of equity using the CAPM.

 If a WACC is needed, use the new cost of equity in the WACC calculation
(calculation outside the scope of the syllabus).

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