Hello,
On 6B, why did you work out a new Beta derived from the one from part A? And why did you rearrange the formula? Could you not have used the same Beta from part A, to work out the cost of equity in part B?

Higher gearing makes the shares more risky and hence the shares have a higher beta.

The formula as it is written gives the asset beta when we know the equity beta. Here we know the asset beta from part (a) and need to calculate the equity beta.

Sir, in calculating the WACC in question 6…why have we assumed 50% as the Market value for both equity and debt. Is the MV for debt not 37.5 (50 x (1.25)? Hence the MV for equity should be 50/87.5 while the MV for debt should be 37.5/87.5. Please clarify.

Thank you the videos. They are highly appreciated. My questions are:

1) If the 1.8 Beta of the Shipping building company has been ungeared giving 1.565 as Beta asset, why do we solve for the 50% cost of equity in question (b) by calculating “Equity / Equity + Debt” again when it already shows that the 1.565 Beta is totally equity with no debt?

2) Why shouldn’t the cost of equity in question (b) be calculated as 50% of 1.565 = 0.7825 multiplied by market risk premium of 10% i.e. (18% – 8%) plus the risk free rate of 8% equal to 15.825%?

1. In part (b) there is debt and therefore the risk of the equity will be higher and therefore the beta of equity will be higher. The higher the gearing the great the equity beta and therefore the greater the cost of equity.

sir why do we not add beta asset of the parent company also to the beta asset of the to-be-bought company (when regearing) to get the overall equity beta of the combined entity?

Thanks for the videos! I really appreciate your work here!
One question regarding the asset beta formula: why is the market value of debt in the denominator multiplied by (1-T)?
This was not the case in the WACC formula, which is why I am confused.
Thanks in advance for a reply!

I have one doubt regarding the use of WACC as a discount rate.

As per previous lectures you said that WACC used as a discount rate for new project only when we have same gearing ratio so here gearing ratio changed then why you use this as a discount rate .

As to example 6 part b, I have no problems in getting BE 2.74 and BA1.565, but why cannot i use the WACC to get the average B of 2.15 and use this beta in CAPM formula to get required rate of 8+2.15(18-8)=29.5%?

Example 6- Part B
Dear sir,
when we Regearing from asset beta to Equity beta, we do that to add our own financial risk to the proxy business risk.
So why we calculate the risk of debt through WACC again?

Dear Sir,
In question (a), required return calculated with asset beta whereas cost of equity calculated with equity beta in question (b). Please help me out of the confusion.
Thank you very much.

The asset beta measure the risk of the business itself (and this is part b).

However shares in the business are more risky because the gearing increases the risk of the shares. The risk of the shares is measured by the equity beta (which is part (a)).

Assuming the entire project was going to be funded by Debt finance instead of equity, how would the cost of appraising the project be determined?

a) Will it be using just CAPM , where the best we use is equal to the asset beta of the ship building company (Exactly how we do it in case the project is funded through equity , could you also tell me what is the logic in doing this if we are doing this) , or

b) Will it be based on WACC. (Again, it would be really helpful if you could show an example of how this might be calculated)

In Example 5 P plc: Debt to Equity ratio of 0.4
Its mean 40% is Debt and 60% is Equity = 100%
But you solve with 100% as Equity and 40% as Debt = 140% how value of compnay above 100%
Same in Q plc

It does not mean 40% is debt and 60% is equity – that would mean a debt to equity ratio os 40/60 which is certainly not 0.4!!

If debt to equity is 0.4, then for every $100 equity the debt is 0.4 x 100 = $40.
Therefore for every $140 total value, the equity is $100 and the debt is $40.

Sir,thank you so much for the wonderful lectures.I would like to know if the 0.2 debt to equity in example 6 can be assumed to be 20% debt and 80% equity to make a total of 100 instead of the 100 equity and 20 debt that you used?A bit confused here sir.Thank you.

No it can’t be assumed to be 20% debt and 80% equity.

If the ratio of debt to equity is given as 0.2, then it means that debt divided by equity is 0.2.
If it were 20% debt and 80% equity, then the ration of debt to equity would be 20/80 which is 0.25 !!

arjunh says

Hello,

On 6B, why did you work out a new Beta derived from the one from part A? And why did you rearrange the formula? Could you not have used the same Beta from part A, to work out the cost of equity in part B?

Thanks

John Moffat says

Higher gearing makes the shares more risky and hence the shares have a higher beta.

The formula as it is written gives the asset beta when we know the equity beta. Here we know the asset beta from part (a) and need to calculate the equity beta.

arjunh says

Thanks, but don’t we have the equity beta from the question which says 1.8?

John Moffat says

1.8 is the equity beta of Y. Y has a gearing ratio of 0.2, but the gearing ratio for the new operation is 0.5.

arjunh says

Oh right thanks! And the gearing ratio for the new operation is 0.5 because the project is financed by 50% debt?

John Moffat says

Exactly 馃檪

YkOdus says

Sir, in calculating the WACC in question 6…why have we assumed 50% as the Market value for both equity and debt. Is the MV for debt not 37.5 (50 x (1.25)? Hence the MV for equity should be 50/87.5 while the MV for debt should be 37.5/87.5. Please clarify.

YkOdus says

37.5 = 50 x (1 minus 25 per cent)* correction

bobbyv39 says

In determining the cost of equity in part (b), why do we calculate a new equity beta rather than just use the given one of 1.8?

John Moffat says

If you are referring to example 6, then 1.8 is the equity beta of Y. We need the equity beta of X and the gearing is different.

Baruwa says

Hi Sir,

Thank you the videos. They are highly appreciated. My questions are:

1) If the 1.8 Beta of the Shipping building company has been ungeared giving 1.565 as Beta asset, why do we solve for the 50% cost of equity in question (b) by calculating “Equity / Equity + Debt” again when it already shows that the 1.565 Beta is totally equity with no debt?

2) Why shouldn’t the cost of equity in question (b) be calculated as 50% of 1.565 = 0.7825 multiplied by market risk premium of 10% i.e. (18% – 8%) plus the risk free rate of 8% equal to 15.825%?

John Moffat says

1. In part (b) there is debt and therefore the risk of the equity will be higher and therefore the beta of equity will be higher. The higher the gearing the great the equity beta and therefore the greater the cost of equity.

2. The same applies as in (1)

Noah098 says

sir why do we not add beta asset of the parent company also to the beta asset of the to-be-bought company (when regearing) to get the overall equity beta of the combined entity?

John Moffat says

We take the weighted average of the betas because the overall risk will be somewhere between the two.

Also, taking the weighted average of the asset betas will certainly not give the equity beta of the combined entity – it will give the asset beta.

phemmersbach says

Thanks for the videos! I really appreciate your work here!

One question regarding the asset beta formula: why is the market value of debt in the denominator multiplied by (1-T)?

This was not the case in the WACC formula, which is why I am confused.

Thanks in advance for a reply!

mukul1988 says

Hi,

I have one doubt regarding the use of WACC as a discount rate.

As per previous lectures you said that WACC used as a discount rate for new project only when we have same gearing ratio so here gearing ratio changed then why you use this as a discount rate .

Thanks

vincentguo says

As to example 6 part b, I have no problems in getting BE 2.74 and BA1.565, but why cannot i use the WACC to get the average B of 2.15 and use this beta in CAPM formula to get required rate of 8+2.15(18-8)=29.5%?

mothuffar says

Example 6- Part B

Dear sir,

when we Regearing from asset beta to Equity beta, we do that to add our own financial risk to the proxy business risk.

So why we calculate the risk of debt through WACC again?

John Moffat says

The WACC isn’t calculating the risk of anything. It is calculating the overall cost to the company of their long-term finance.

gnoii says

Dear Sir,

In question (a), required return calculated with asset beta whereas cost of equity calculated with equity beta in question (b). Please help me out of the confusion.

Thank you very much.

gnoii says

Example 6, please.

John Moffat says

The asset beta measure the risk of the business itself (and this is part b).

However shares in the business are more risky because the gearing increases the risk of the shares. The risk of the shares is measured by the equity beta (which is part (a)).

akhalid93 says

In Examples: To calculate the Cost of Debt 8% x 0.75 is taken. This 0.75 is (1-T). The 6% answer is After-Tax Cost of Debt?

John Moffat says

Yes.

annamalai27 says

Hi sir,

In example 6,

Assuming the entire project was going to be funded by Debt finance instead of equity, how would the cost of appraising the project be determined?

a) Will it be using just CAPM , where the best we use is equal to the asset beta of the ship building company (Exactly how we do it in case the project is funded through equity , could you also tell me what is the logic in doing this if we are doing this) , or

b) Will it be based on WACC. (Again, it would be really helpful if you could show an example of how this might be calculated)

umartamoor says

Dear Sir,

In Example 5 P plc: Debt to Equity ratio of 0.4

Its mean 40% is Debt and 60% is Equity = 100%

But you solve with 100% as Equity and 40% as Debt = 140% how value of compnay above 100%

Same in Q plc

John Moffat says

Nobody is talking about %’s !!!!

It does not mean 40% is debt and 60% is equity – that would mean a debt to equity ratio os 40/60 which is certainly not 0.4!!

If debt to equity is 0.4, then for every $100 equity the debt is 0.4 x 100 = $40.

Therefore for every $140 total value, the equity is $100 and the debt is $40.

Denay says

In example 6, when calculating the beta of equity, why did you take 87.5/50 rather than 50/87.5 seeing has the formula had not changed sides?

John Moffat says

But the formula has ‘changed sides’.

We have calculated the asset beta and are using the formula to calculate the equity beta, which means reversing the formula.

guardian96 says

Hi John

In the final calculation of WACC shouldn’t we take the tax effect of debt?

toyin1234 says

Sir,thank you so much for the wonderful lectures.I would like to know if the 0.2 debt to equity in example 6 can be assumed to be 20% debt and 80% equity to make a total of 100 instead of the 100 equity and 20 debt that you used?A bit confused here sir.Thank you.

John Moffat says

No it can’t be assumed to be 20% debt and 80% equity.

If the ratio of debt to equity is given as 0.2, then it means that debt divided by equity is 0.2.

If it were 20% debt and 80% equity, then the ration of debt to equity would be 20/80 which is 0.25 !!

toyin1234 says

Thank you sir,I do get the logic now.

John Moffat says

You are welcome 馃檪