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ACCA Strategic Professional · Advanced Financial Management · Discounted cash flow techniques

A proxy company has an equity beta of 1.20, a debt beta of zero, and a market value gearing of debt:equity of 1:3. Tax is 25%. Using the formula βa = βe × E/(E + D(1−t)), what is the proxy's asset beta?

The asset beta is 0.96. With debt:equity of 1:3 and 25% tax, equity plus after-tax debt is 3.75, so asset beta is 1.20 multiplied by 3 over 3.75, giving 0.96. This strips out the financial risk from the proxy's equity beta.

  1. A0.96
  2. B0.80
  3. C0.90Correct
  4. D1.00

Explanation

With E = 3 and D = 1, E + D(1−t) = 3 + 0.75 = 3.75. Asset beta = 1.20 × 3/3.75 = 1.20 × 0.8 = 0.96. Checking: 3.6/3.75 = 0.96. The option 0.90 is therefore wrong, and the correct one is 0.96. Option 0.80 results from omitting the 1.20 multiplier, and 1.00 comes from ignoring tax incorrectly.

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