Page 114 - AFM Integrated Workbook STUDENT S18-J19

Chapter 6

Question 1

Scafell Co is an unlisted training and publishing company. The finance director
is attempting to use the Capital Asset Pricing Model (CAPM) to derive the
company’s cost of equity.

Important financial information

Listed companies in the training sector have an average equity beta of 1.80,
and an average gearing ratio (debt to equity) of 1:1.

Listed companies in the publishing sector have an average equity beta of 1.20,
and an average gearing ratio (debt to equity) of 1:2.

Approximately 60% of Scafell Co’s operating profits are generated from the
training sector and the other 40% from the publishing sector.

Scafell Co has a gearing ratio (debt to equity) of 1:3. Its debt can be
considered to be risk free.

The corporate tax rate is 20%, the risk free rate of interest is 5% and the equity
risk premium is 6.5%.

Required:

Calculate the cost of equity of Scafell Co using the CAPM.

Solution

In order to use CAPM we need to derive a suitable equity beta for Scafell Co.

This will be done by first finding a suitable asset beta (based on the asset
betas of the 2 parts of the business) and gearing up to reflect Scafell Co's 1:3
gearing level.

Training industry

The asset beta of training operations can be found from the industry
information as follows: (assuming the debt beta is zero)

V E 1
ß = ß =1.80 1.00
e
a
V + V [1 – T] 1 + 1[1 – 0.20]
D
E

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