Skip to content

ACCA Strategic Professional · Advanced Financial Management · Impact of financing on investment decisions and adjusted present values

A proxy company in the same business as a proposed project has an equity beta of 1.2 and a debt-to-equity market value ratio of 1:3. The tax rate is 25%, and debt is assumed to be risk-free (debt beta of zero). The risk-free rate is 4% and the market risk premium is 5%. What ungeared cost of equity should be used to discount the project's base-case cash flows?

The ungeared cost of equity is 8.8%. The asset beta is 1.2 × 3 / (3 + 0.75) = 0.96, which allows for the tax relief on debt. Applying CAPM gives 4% + 0.96 × 5% = 8.8%.

  1. A8.8%Correct
  2. B8.5%
  3. C10.0%
  4. D11.5%

Explanation

Asset beta = βe × E / (E + D(1−T)) = 1.2 × 3 / (3 + 0.75) = 0.96. Ungeared cost of equity = 4% + 0.96 × 5% = 8.8%. Ignoring tax in the gearing adjustment gives 0.9 and 8.5%. Using the geared equity beta gives 10%.

Did you get it right without looking?

One question tells you little. A timed set on Impact of financing on investment decisions and adjusted present values shows your real accuracy, how long you take and where you lose marks.

Practise Impact of financing on investment decisions and adjusted present valuesFree diagnostic mock

More Impact of financing on investment decisions and adjusted present values questions