7. Asset versus Equity Betas Suppose Zenos Manufacturing is contemplating invest

Question

7. Asset versus Equity Betas Suppose Zenos Manufacturing is contemplating investing in a new business and would like to estimate cost of capital in this new business. An existing company, ABC firm in the target industry has an equity beta of 0.90 but is very conservatively financed with a market value, equity-to-value rtio 95% ( ie,--0.95). Note: Portfolio-p Asset-D-E assuming Belt=0; Phisct D+E (I+ AssetD+ E Equity , PEquity- 'Asset a. Assuming ABC firm's debt beta is zero, calculate ABC firm's asset beta Since Zenos' new business line will be in the same industry with ABC firm, let's assume that they have thesameassetbeta. Zenos intends to use an equity-to-value ratio of 30% (i.e., b. = 0.30) and wonders what beta to use in estimating a cost of capital in the new business. D+E Assuming Zenos' debt beta is zero, estimate its equity beta for this new business line.

Explanation / Answer

a). Solution :- Calculation of asset beta (Asset) of ABC firm :-

Asset = 0.95 * 0.90 + (1 - 0.95) * 0

= 0.855 + 0

= 0.855

Conclusion :- Asset beta (Asset) of ABC firm = 0.855

b). Solution :- Calculation of equity beta (Equity) of Zenos :-

0.855 = 0.30 * Equity + (1 - 0.30) * 0

0.855 = 0.30 Equity + 0

Equity = 0.855 / 0.30

Equity = 2.85

Conclusion :- Equity beta (Equity) of Zenos = 2.85

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