ACCA AFM Syllabus B3cd. The Cost of Capital - Ungearing & Regearing - Notes 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:
Debt/equity amounts remain unchanged
Operating risk of firm stays same
Finance is not project specific (so the average is applicable)
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
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)
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
STEP 1
Ungear the ß of the proxy company:
ßu = ßg [Ve/(Ve + Vd (1 - t))]
= 1⋅4 x 4/4⋅7 = 1⋅1915
STEP 2
Regear the ß:
ßg = 1⋅1915 x (5 + 2 (1 - 0⋅3))/5
= 1⋅525THEN APPLY THIS TO THE CAPM FORMULA