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Capital structure

Question 6

CAPM and gearing risk

Burke Co is an all equity clothing retailer who is about to diversify into food
sales. Its current equity beta is 1.3. The corporation tax rate is 30%
Gearing in the food sales industry averages 80% equity, 20% debt.

Some representative asset betas for firms in the food sales industry are:
Frost Co 1.6, Vasquez Co 1.7, Ferro Co 1.75.

Calculate appropriate betas for Burke Co to use in evaluation of the food sales
business if its restructures its capital in the following ways:

(i) Burke Co remains an all equity company

(ii) Burke Co gears up to 10% debt and 90% equity

As the proxy betas given are all asset betas they will not need to be de-geared.
As there are 3 a simple average of them is calculated to use as the proxy:

(1.6 + 1.7 + 1.75)/3 = 1.683

(i) If Burke remains an all equity company then the asset beta and the equity
beta will be the same and so it can directly use the proxy of 1.683
(ii) If Burke gears up it will need to gear up the proxy asset beta too.

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

1.683 = 90/(90 + (10 × 0.7)) × β e

1.683 = 90/97 × β e

β e = 1.683/0.9278 = 1.814

Illustrations and further practice

Now work through illustration 1 and try TYU question 6 from Chapter 18.

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