Question

c. Judy Chen is the primary portfolio manager of the global equities portfolio at Horizon Asset Management. Lars Johansson, a recently hired equity analyst, has been assigned to Chen to assist her with the portfolio. Chen asks Johansson to evaluate Twin Industries, a privately owned U.S. company that may initiate a public stock offering. Johansson decides to use CAPM to estimate the required return on equity for Twin Industries. Johansson identifies a publicly traded peer company with an estimated equity beta of 1.09. Twin Industries is funded 49% by debt and 51% by equity. The publicly traded peer company is funded 60% by debt and 40% by equity. The risk-free rate is 4%. The average return on the S&P 500 index for the past 5 years is 8%. Assume that debt is risk-less and there is no tax.

1.Estimate the equity beta for Twin Industries.

2. What is the required return on equity for Twin Industries?

Answer 1

D/E of public company = 0.6/0.4=1.5

D/E of twin industries = 0.49/0.51=0.9607

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

1.09 = Unlevered Beta*(1+((1-0)*(1.5)))

Unlevered Beta = 0.44

1

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

levered beta = 0.44*(1+((1-0)*(0.9607)))

levered beta = 0.86

2

As per CAPM

expected return = risk-free rate + beta * (expected return on the market - risk-free rate)

Expected return% = 4 + 0.86 * (8 - 4)

Expected return% = 7.44