Page 138 - AFM Integrated Workbook STUDENT S18-J19

Chapter 7

Question 1

Metal Co is a manufacturing company. The directors are considering
undertaking a new project in the retail sector.

Listed manufacturing companies have an average equity beta of 1.45 and an
average gearing ratio (debt to equity by market values) of 20:80.

Listed retail companies have an average equity beta of 1.10 and an average
gearing ratio (debt to equity by market values) of 40:60.

Metal Co has a gearing ratio (debt to equity by market values) of 50:50, and
this is expected to stay constant after undertaking the new project.

The debt beta can be assumed to be zero. The risk free rate of interest is 4%
and the average return on the stock market is 12%.

The corporation tax rate is 20%.

Required:

Calculate a suitable cost of capital to apply to the new project.

Solution

The asset beta of retail companies can be found from the industry information
as follows: (given that the debt beta is zero)

V 60
ß = ß E =1.10 =0.72
e
a
V + V [1 – t] 60 + 40[1 – 0.20]
E
D
Regearing this asset beta to reflect Metal Co’s gearing now gives:
0.72 = ß e × [50/(50 + 50(1 – 0.20))]

So, ß e = 0.72/0.56 = 1.29

Risk adjusted cost of equity

Using CAPM:

k e = R F + ß (E(R M) – R F) = 4% + [1.29 × (12% – 4%)] = 14.3%

126