ExpertMedium2 marksMultiple Choice
ACCA · Question 10 · Estimating the Cost of Capital
Section A
CyberShield Inc, a software company, is pivoting to hardware manufacturing. To find an appropriate discount rate, it looks at a proxy hardware company, HardTech PLC.
HardTech PLC has an equity beta of 1.5. Its capital structure is 60% equity and 40% debt by market value. The corporate tax rate is 25%.
Assuming debt is risk-free (debt beta is zero), what is the asset beta of HardTech PLC?
Section A
CyberShield Inc, a software company, is pivoting to hardware manufacturing. To find an appropriate discount rate, it looks at a proxy hardware company, HardTech PLC.
HardTech PLC has an equity beta of 1.5. Its capital structure is 60% equity and 40% debt by market value. The corporate tax rate is 25%.
Assuming debt is risk-free (debt beta is zero), what is the asset beta of HardTech PLC?
Answer options:
A.
0.90
B.
1.00
C.
1.13
D.
1.50
How to approach this question
Use the asset beta formula (un-gearing formula): βa = βe × [Ve / (Ve + Vd(1-T))]. Substitute the given values: βe = 1.5, Ve = 60, Vd = 40, T = 0.25.
Full Answer
B.1.00✓ Correct
To find the asset beta (un-geared beta), we strip out the financial risk of the proxy company using the formula:
βa = βe × [E / (E + D(1-t))]
βa = 1.5 × [60 / (60 + 40(1 - 0.25))]
βa = 1.5 × [60 / (60 + 30)]
βa = 1.5 × (60 / 90)
βa = 1.5 × 0.6667 = 1.00.
Common mistakes
Forgetting to apply the tax rate to the debt value, which would result in 1.5 * (60/100) = 0.90.
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