The total market value of the equity share of ORE Company is Rs 60,00,000 and the total value of the debt is Rs 40,00,000. The treasurer estimates that the beta of the stock is currently 1.5 and that the expected risk premium on the market is 10 per cent. The treasury bill rate is 8 per cent.

Question

The total market value of the equity share of ORE Company is Rs 60,00,000 and the total value of the debt is Rs 40,00,000. The treasurer estimates that the beta of the stock is currently 1.5 and that the expected risk premium on the market is 10 per cent. The treasury bill rate is 8 per cent.
[latex]Required:[/latex] (i) What is the beta of the company’s existing portfolio of assets? (ii) Estimate the company’s cost of capital and the discount rate for an expansion of the company’s present business.

Accepted Answer

(i) Beta of existing portfolio of assets [latex](ba)[/latex]
[latex]\,[/latex] [Beta of equity [latex](b_e)[/latex] × Value of equity [latex](V_e)[/latex]/Total value of firm [latex](V_o)[/latex]] +
[latex]\,[/latex] [Beta of debt [latex](b_d)[/latex] × Value of debt [latex](V_d)[/latex]/Total value of firm [latex](V_o)[/latex]]
[latex]\quad ba[/latex] = 1.5 × (Rs 60 lakh/Rs 100 lakh, ie, Rs 60 lakh + Rs 40 lakh) = 0.9.
[latex]\,[/latex] Note: In the absence of [latex](b_d)[/latex], it is assumed to be zero.
(ii) Cost of capital
[latex]\quad ke[/latex] = Risk free rate of return + (Risk premium x ba) = 8% + (10% x 0.9) = 17
[latex]\,[/latex] per cent.
[latex]\,[/latex] 17 per cent discount rate should be used to evaluate the company’s
[latex]\,[/latex] investments in the expansion of business.

Question 9.RQ.20: The total market value of the equity share of ORE Company is......

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