AFMP4
Syllabus B3cd. The Cost of CapitalCost of equity

Ungearing & Regearing 5 / 5

Ungearing & Regearing

When to use WACC to appraise investments

The WACC calculations we made earlier were all based on CURRENT costs and amounts of debt and equity. 

So use this as a cost for other future projects where:

  1. Debt/equity amounts remain unchanged

  2. Operating risk of firm stays same

  3. Finance is not project specific (so the average is applicable)

  4. Project is relatively small so any changes to the company are insignificant.

If any if the above do not apply - then we cannot use WACC. We then have to use CAPM.. adapted…

Ungearing & Regearing

The betas we have been looking at so far are called Equity Betas

These represent :

  • Business Risk

  • Our Financial Risk (Our gearing)

If we are looking to invest into a different industry we need to use a different beta, one which represents:

  • Business Risk (of new industry)

  • Financial Risk (Ours still as we are using our debt and/or equity)

To do this - follow these 2 simple steps

  1. Ungearing

    Take the equity beta of a business in the target industry. 

    Remember, this will represent their business risk and their financial risk (gearing). 

    We only want their business risk. 

    So we need to take out the financial risk - this is called ungearing

    Business equity beta x Equity / Equity + Debt

    This will leave us with business risk only (asset beta)

  2. Re-Gearing

    Take this asset beta and regear it using our gearing ratio as follows:

    Asset Beta x Equity + Debt / Equity

    *Remember Debt is tax deductible

Illustration

Tax = 30%

  Main company Proxy company
Equity beta 1⋅1 1⋅4
Gearing 2⋅5 1⋅4

Find the appropriate beta for the main company to use in its CAPM for investing in an industry different to its own but the same as the proxy company

  1. STEP 1

    Ungear the ß of the proxy company:

    ßu = ßg [Ve/(Ve + Vd (1 - t))]

    = 1⋅4 x 4/4⋅7 =  1⋅1915

  2. STEP 2

    Regear the ß:

    ßg = 1⋅1915 x (5 + 2 (1 - 0⋅3))/5
    = 1⋅525

    THEN APPLY THIS TO THE CAPM FORMULA