Question

North Pole Fishing Equipment Corporation and South Pole Fishing Equipment Corporation would have identical equity betas of 1.21 if both were all equity financed. The market value information for each company is shown here:

  

	North Pole			South Pole
Debt	$	3,010,000		$	3,910,000
Equity	$	3,910,000		$	3,010,000

  

The expected return on the market portfolio is 12 percent, and the risk-free rate is 4.3 percent. Both companies are subject to a corporate tax rate of 35 percent. Assume the beta of debt is zero.

  

a.	What is the equity beta of each of the two companies? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

  

	Equity beta
North Pole
South Pole

  

b.	What is the required rate of return on each of the two companies’ equity? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

  

	Rate of return
North Pole	%
South Pole	%

Answer 1

a. Equity Beta = (1 + [(1 - Tax) * DE Ratio)] * Beta Unlevered

North Pole Beta = (1 + [(1 - 0.35) * (3010000 / 3910000)]) * 1.21 = 1.82

South Pole Beta = (1 + [(1 - 0.35) * (3910000 / 3010000)]) * 1.21 = 2.23

b.

CAPM = Risk Free + Beta * (Market risk premium)

North Pole Expected rate of return = Risk Free + Beta * (Market risk premium)

North Pole Expected rate of return = 4.30% + 1.82 * (12%-4.30%)

North Pole Expected rate of return = 18.31%

South Pole Expected rate of return = Risk Free + Beta * (Market risk premium)

South Pole Expected rate of return = 4.30% + 2.23 * (12%-4.30%)

South Pole Expected rate of return = 21.47%