Equity Beta & Changes in Gearing Level

Equity Beta & Changes in Gearing Level

Equity beta for company tends to change with change level of gearing, because equity beta incorporates financial risk and business risk, equity beta tend to increase with increased level of gearing.

1.    equity Beta increase with increased level of Gearing

2.    Cost of Equity increase with increased level of Gearing

Equity Beta Example for change in Gearing

A company has total value of $ 100 million, which includes 60% equity & 40% debt. The other information are given below

Cost of Equity Company = 14%

Cost of Debt= 8%

Tax Rate = 30%

Equity Beta = .88

Market Rate = 12%

Issue new $ 20 million to pay debt

Solution

1.    Asset Beta Calculation

βa = [Ve/Ve + Vd (1-t)] x βe

= [60/60 + 40(1-30%)] x .88

= [60/60+28] x.88

=[60/88]x.88

=.68x.88

=.6

2.    Value of Un Geared Company

Vg =Vu + TD

100= Vu +( 40)x(30%)

100=Vu+12

Vu=88

3.    Value of Geared Company (New Gearing)

Vg =Vu + TD

= 88 + 20 (30%)

=88+6

=94

4.    Change Financial Structure

Total Value = 94

Debt= 20

Equity= 74

5.    Equity Beta for Change Structure

βe = [Ve + Vd (1-t)/Ve] x βa

= [74+ 20 (1-30%)/74] x .6

=[74+20.7/74]x.6

=1.279 x .6

=.767

6.    Cost of Equity for Changed Structure

CAPM = Rf + βe (Rm-Rf)

=  8% + .767 ( 12%-8%)

=8%+3%

=11%

it can be noted that cost of equity of company has came down due to decreased level of Gearing.