Page 330 - AFM Integrated Workbook STUDENT S18-J19

Chapter 15

Question 2

Foxes Co is an unlisted company. Its gearing ratio (debt to equity) is 20:80.

The directors are attempting to calculate the company’s cost of equity. Since
Foxes Co is unlisted, they have been unable to calculate a beta factor for the
company. However, they have discovered that the company’s main competitor,
Badgers Co (a listed, ungeared company in the same industry) has a cost of
equity of 15%.

The corporate tax rate is 20%, and the risk free rate of interest is 4%. Foxes
Co’s debt finance can be assumed to be risk free.

Required:

Estimate the cost of equity of Foxes Co, using Modigliani and Miller’s
Proposition 2 formula.

Solution

Using M & M's formula, and assuming that the ungeared competitor’s cost of
equity is a suitable proxy for Foxes Co’s ungeared cost of equity:
i
i
k e = k e + (1-T)(k e – k d) V d / V e
k e = 15% + (1-0.20)(15%–4%)×20/80 = 17.2%

318