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 1.29 if both were all equity financed. The market value information for each company is shown here: North Pole South Pole Debt $ 3,090,000 $ 3,990,000 Equity $ 3,990,000 $ 3,090,000 The expected return on the market portfolio is 12.8 percent, and the risk-free rate is 5.1 percent. Both companies are subject to a corporate tax rate of 34 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

Unlevered beta for both companies = 1.29.

Now, For north Pole

Value of debt = $3,090,000

Value of equity = $3,990,000

Levered beta is calculated below:

Levered beta = unlevered beta × [1 + (1 - tax rate) x (Debt/Equity)]

                      = 1.29 × [1+ (1 – 34%) × ($3,090,000 / $3,990,000)]

                      = 1.29 × [1+ 0.51]

                      = 1.95

So, Levered beta for north Pole is 1.95.

Now required return for north Pole is calculated below using CAPM model:

Expected rate of return = Risk free rate + (Market Return - Risk free rate) × Beta

=  5.10% + (12.80% - 5.10%) × 1.95

                                      = 5.10% + (7.70% × 1.95)

                                      = 5.10% + 15.01%

                                      = 20.11%

Hence, required return for north Pole is 20.11%.

Now, For South Pole

Value of debt = $3,990,000

Value of equity = $3,090,000

Levered beta is calculated below:

Levered beta = unlevered beta × [1 + (1 - tax rate) x (Debt/Equity)]

                      = 1.29 × [1+ (1 – 34%) × ($3,990,000 / $3,090,000)]

                      = 1.29 × [1+ 0.85]

                      = 2.39

So, Levered beta for south Pole is 2.39.

Now required return for south Pole is calculated below using CAPM model:

Expected rate of return = Risk free rate + (Market Return - Risk free rate) × Beta

=  5.10% + (12.80% - 5.10%) × 2.39

                                      = 5.10% + (7.70% × 2.39)

                                      = 5.10% + 18.40%

                                      = 23.50%

Hence, required return for south Pole is 23.50%.

Related Questions

Navigate

• Browse (All)
• Browse N
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.