Question

You are helping the CFO of a manufacturing company assess whether the firm should embark on a plan to reduce its financial leverage. The firm currently has equity with a market value of S 350 million and debt outstanding (in market value terms) of $ 700 million. The cost of equity currently is 10% and the pre- tax cost of borrowing is 8%. (The riskfree rate is 2.5% , the tax rate is 40% and the equity risk premium is 6%) B) What is Beta at the current cot of equity? Round to to Decimals

Answer 1

As per capital asset pricing model (CAPM), the cost of equity for the company is calculated by using the following formula

Cost of Equity = Rf + [Beta x Equity Risk Premium]

Where, Cost of Equity = 10%

Risk-free rate (Rf) = 2.50%

Equity Risk Premium (Rm – Rf) = 6%

Beta = ?

After substituting the given data’s into the equation, we get

Cost of Equity = Rf + [Beta x Equity Risk Premium]

0.10 = 0.0250 + [Beta x 0.06]

0.10 – 0.0250 = [Beta x 0.06]

0.0750 = [Beta x 0.06]

Beta = 0.0750 / 0.06

Beta = 1.25

“Therefore, the Beta at the current cost of Equity would be 1.25”