North Pole Fishing Equipment Corporation and South Pole Fishing Equipment Corpor

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 $ 2,910,000 $ 3,810,000 Equity $ 3,810,000 $ 2,910,000 The expected return on the market portfolio is 11 percent, and the risk-free rate is 3.3 percent. Both companies are subject to a corporate tax rate of 40 percent. Assume the beta of debt is zero.

a. What is the equity beta of each of the two companies? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) Equity beta North Pole, South Pole

b. What is the required rate of return on each of the two companies’ equity? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) Rate of return North Pole %, South Pole %

Explanation / Answer

a.

Equity beta of a firm is the unlevered beta. Each firm's unlevered beta is 1.11, find the equity beta for each

Equity beta = [1+(1-T)(D/E)]*unlevered beta

North Pole:

Equity beta = (1+(1-0.4)*(2910000/3810000))*1.11 = 1.62

South Pole:

Equity beta = (1+(1-0.4)*(3810000/2910000))*1.11 = 1.98

b.

According to CAPM,

Required return = risk free rate + beta*(Market return - risk free rate)

North Pole:

Required return = 0.033 + 1.62*(0.11-0.033) = 0.1576 = 15.76%

South pole:

Required return = 0.033 + 1.98*(0.11-0.033) = 0.1856 = 18.56%

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