Advanced Financial

Management
Assignment 2 – Group 4

Krista Busta 3116999144

Svetlana Hahina 3116999135
Asif Abdullah 3116999152
Joel Pérez 3116999164
Introduction

Solve the Problem

CAPM Model

Effects of Debt in a Company value.

 Question 1
• The directors of Moorland Co, a company which has 75% of its operations in the
retail sector and 25% in manufacturing, are trying to derive the firm's cost of
equity. However, since the company is not listed, it has been difficult to determine
an appropriate beta factor. Instead, the following information has been
researched:
• Retail industry - quoted retailers have an average equity beta of 1.20, and an
average gearing ratio of 20:80 (debt / equity).
• Manufacturing industry - quoted manufacturers have an average equity beta of
1.45 and an average gearing ratio of 45:55 (debt /equity).
• The risk free rate is 3% and the equity risk premium is 6%. Tax on corporate profits
is 30%. Moorland Co has gearing of 50% debt and 50% equity by market values.
Assume that the risk on corporate debt is negligible.
• Required:
• Calculate the cost of equity of Moorland Co using the CAPM model.
Data
Moorland Info. %
Gearing 50/50
Measure Retail Manufactoring
Retail Participation 75% β average 1,2 1,45
Manufactoring P. 25% Average 20/80 45/55

Corporate debt is
Market
Information %
Rf 3%
Risk Premium
Tax
6%
30% negligible!
Solution
1. Ungear the βe for every
sector.

2. Compute the β of the

portfolio.

3. Re-Gear the beta

according the leverage level
of the Company.
4. Calculate the Ke using the
CAPM model and the
computed Beta.
What is the Beta?
 Solution
Explanation Solution
• When we assume that the risk
on corporate debt is negligible,
the formula for Beta of the
assets (βa) change.
 Solution
Explanation Solution
• Now, we just put the values Retail
into the formula and calculate • 𝜷𝒂 =
𝟎.𝟖
× 𝟏. 𝟐 =
𝟎.𝟖+𝟎.𝟐×(𝟏−𝟎.𝟑)
the βa for every sector. 𝟏. 𝟎𝟐

Manufacturing
𝟎.𝟓𝟓
• 𝜷𝒂 = × 𝟏. 𝟒𝟓 =
𝟎.𝟓𝟓+𝟎.𝟒𝟓×(𝟏−𝟎.𝟑)
𝟎. 𝟗𝟐
 Solution
Explanation Solution
• Now, we can use this two Betas • β of the portfolio:
in Moorland, computing an • βp= 0.75 × 1.02 + 0.25 × 0.92= 1
weighted average or Beta of
the portfolio.
𝟎.𝟓+𝟎.𝟓×(𝟏−𝟎.𝟑)
• Then, we must re-gear the Beta • βe= × 𝟏 = 𝟏. 𝟔𝟗
𝟎.𝟓
according to the capital
structure or Moorland.
 Solution
Explanation Solution
• Now we can calculate the Ke, • Ke = 3% + 1.69 × 6% = 13.1%
using CAPM model.