ACCA FM · Chapter 12 · Question 7 of 9
A company is evaluating a project in a new industry. A proxy company in that industry has an equity beta of 1.5 and debt to equity of 25:75. The company's own debt to equity is 20:80. Tax is 20%, debt is risk free, the risk-free rate is 3% and the market risk premium is 6%. What is the project-specific cost of equity (to 2 decimal places)?
Test yourself: pick an answer
Reveal answer & explanation
Correct answer: C) 11.53%
Explanation
Ungear the proxy beta: asset beta = 1.5 x 75 / (75 + 25 x 0.8) = 1.1842. Regear at the company's gearing: equity beta = 1.1842 x (80 + 20 x 0.8) / 80 = 1.4211. Ke = 3% + 1.4211 x 6% = 11.53%. Using the proxy beta unadjusted gives 12.00%, and using the asset beta gives the ungeared cost of equity of 10.11%.
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