Question

Problem 18-5 Beta and Leverage

North Pole Fishing Equipment Corporation and South Pole Fishing Equipment Corporation would have identical equity betas of 1.16 if both were all equity financed. The market value information for each company is shown here:

  

	North Pole			South Pole
Debt	$	3,010,000		$	3,920,000
Equity	$	3,920,000		$	3,010,000

  

The expected return on the market portfolio is 11.9 percent and the risk-free rate is 3.9 percent. Both companies are subject to a corporate tax rate of 21 percent. Assume the beta of debt is zero.

  

a.	What is the equity beta of each of each company? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)
b.	What is the required rate of return on equity for each company? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

Unlevered or Asset beta of south pole and North pole   1.16
Tax rate is 21% or 0.21  
  
Levered beta or Equity beta formula = Unlevered or Asset beta * (1 +( (1-tax rate)*Debt/Equity))  
North pole equity Beta = 1.16*(1+((1-0.21)*3010000/3920000))  
1.863664286  
1.86  
  
South Pole equity Beta =    1.16*(1+((1-0.21)*3920000/3010000))
2.353451163  
2.35  
Risk free rate of return=   3.90%
Market Return =   11.90%
  
Required Return on equity formula as per CApM method = Risk free rate +(Equity beta*(Market Return-Risk free rate))  
North Pole Required Return of equity = 3.9%+(1.863664286*(11.9%-3.9%))  
18.81%  
  
South Pole Required Return of equity = 3.9%+(2.353451163*(11.9%-3.9%))  
22.73%  
  
North pole equity beta =   1.86
south Pole equity Beta =    2.35
North Pole Required Return of equity   18.81%
South Pole Required Return of equity   22.73%