Question

North Pole Fishing Equipment Corporation and South Pole Fishing Equipment Corporation would have identical equity betas of 1.11 if both were all equity financed. The market value information for each company is shown here:

North Pole			South Pole
Debt		$2,960,000			$3,870,000
Equity		$3,870,000			$2,960,000

The expected return on the market portfolio is 11.4 percent and the risk-free rate is 3.4 percent. Both companies are subject to a corporate tax rate of 21 percent. Assume the beta of debt is zero.

What is the equity beta of North Pole?

What is the equity beta of South Pole?

What is the required rate of return on equity for North Pole?

Answer 1

The equity beta of North Pole is computed as shown below:

= [ 1 + (1 - tax rate) x (Debt / Equity) ] x Beta of unlevered

= [ 1 + (1 - 0.21) x ($ 2,960,000 / $ 3,870,000) ] x 1.11

= 1.604237726 x 1.11

= 1.780703876 or 1.78 Approximately

The equity beta of South Pole is computed as shown below:

= [ 1 + (1 - tax rate) x (Debt / Equity) ] x Beta of unlevered

= [ 1 + (1 - 0.21) x ($ 3,870,000 / $ 2,960,000) ] x 1.11

= 2.032871622 x 1.11

= 2.26 Approximately

The required rate of return on equity for North Pole is computed as shown below:

= risk free rate + beta x ( return on market - risk free rate)

= 0.034 + 1.780703876 x (0.114 - 0.034)

= 17.65% Approximately

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