Question

Beta and Leverage: North Pole Fishing Equipment Corporation and South Pole Fishing Equipment Corporation would have identical equity betas of 1.10 if both were all-equity financed. Assume, based on financial information provided to you, that you calculate the equity beta for North Pole is 1.50, and you calculate that for South Pole is 2.00. The expected return on the market portfolio is 10.9 percent, and the risk-free rate is 3.2 percent. both companies are subject to a corporate tax rate of 35%. Assume the beta of debt is 0. What is the required rate of return for the equity of North Pole Fishing Equipment Corporation? 14.75 percent 19.55 percent 9.95 percent None of these values are correct.

Answer 1

Required rate of return using CAPM model = risk free rate + beta( expected market return - risk free rate)

Required rate of return = 0.032 + 1.5( 0.109 - 0.032)

Required rate of return = 0.032 + 0.1155

Required rate of return = 0.1475 or 14.75%

I know you have mentioned 14.75% is not one of the answers but if you have calculated 1.50 to be the equity beta, then required rate will be 14.75%. I have encountered this question before and we were asked to calculate the equity beta. The equity beta calculated was a different one than what you have given which is 1.5. Please check if you have calculateed equity beta of north pole correctly.