ExpertHard2 marksMultiple Choice
ACCA · Question 06 · Estimating the Cost of Capital
Section A
LexAI, an AI-driven legal services firm, is entirely equity financed with an equity beta of 1.4. It plans to diversify into a new industry (cloud data storage) and has identified a proxy company in that industry. The proxy company has an equity beta of 1.2 and a debt-to-equity ratio of 1:3 by market value. The corporate tax rate is 25%.
What is the asset beta of the proxy company? (Round to two decimal places)
Section A
LexAI, an AI-driven legal services firm, is entirely equity financed with an equity beta of 1.4. It plans to diversify into a new industry (cloud data storage) and has identified a proxy company in that industry. The proxy company has an equity beta of 1.2 and a debt-to-equity ratio of 1:3 by market value. The corporate tax rate is 25%.
What is the asset beta of the proxy company? (Round to two decimal places)
Answer options:
A.
0.90
B.
0.96
C.
1.12
D.
1.50
How to approach this question
Use the asset beta formula: Ba = Be * [Ve / (Ve + Vd(1-T))]. The proxy company's D:E is 1:3, meaning Vd = 1 and Ve = 3.
Full Answer
B.0.96✓ Correct
To find a project-specific discount rate, we must first un-gear the proxy company's equity beta to find its asset beta (business risk).
Formula: Ba = Be * [Ve / (Ve + Vd(1-T))]
Ba = 1.2 * [3 / (3 + 1(1 - 0.25))]
Ba = 1.2 * [3 / 3.75]
Ba = 1.2 * 0.8 = 0.96.
Common mistakes
Using LexAI's equity beta (1.4) instead of the proxy company's beta, or misinterpreting the D:E ratio of 1:3 as Ve=1, Vd=3.
Practice the full ACCA FM — Financial Management Practice Exam 6
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