Question

North Pole Fishing Equipment Corporation and South Pole Fishing Equipment Corporation would have identical equity betas of 1.25 if both were all equity financed. The market value information for each company is shown here:

  

	North Pole			South Pole
Debt	$	3,100,000		$	4,010,000
Equity	$	4,010,000		$	3,100,000

  

The expected return on the market portfolio is 12.8 percent and the risk-free rate is 4.8 percent. Both companies are subject to a corporate tax rate of 25 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

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Answer:

a.  In general,

β_Equity = {1 + [(1 - T_c)Debt / Equity]}β_{Unlevered Firm}

Therefore,

β_{North Pole} = {1 + [(1 - 0.25)$3,100,000 / $4,010,000]}1.25 = 1.97475

β_{South Pole} = {1 + [(1 - 0.25)$4,010,000 / $3,100,000]}1.25 = 2.4627

b. Just need to apply the CAPM formula here

R_{North Pole} = r_f + β_{North Pole}(R_m - R_f)

= 4.80% + 1.97(12.80% - 4.80%)

= 20.60%

R_{South Pole}= r_f + β_{South Pole}(R_m - R_f)

= 4.80% + 2.4627(12.80% - 4.80%)

=24.50%