Topic:What Are The Risk in Diversifing Investment in New Industry?
Question -The company wants to diversify its risk by investing in a new industry. Alpha is a long established supplier and acquiring Alpha Plc would add substantially to the market capitalisation of the business. The board of directors want to explore whether Alpha Plc is worthy of investment. Alpha Plc is currently all equity based.
In order to assess the operating risk of the company, you decide to use the asset beta extracted from other proxied companies in the same industrial sector as detailed below.
i. Abbot Plc is an all equity company. Its equity beta is 1.05. It has been estimated that 35% of the current value of the company is related to higher risk projects, these projects carry a beta of 1.26. The remaining projects have a similar risk.
ii. Broadridge Inc is financed by 30% debt and 70% equity and their equity beta is estimated as 1.34.
iii. Cecilia Plc has an equity beta of 1.20. Its capital structure is two thirds equity and one third debt. The company has two divisions of operations, A and B. Division A has similar operations but those of B operation are 40% more risky than those of A. It is estimated that Division A accounts for 60% of the total value of Cecilia Plc.
iv. Ecolab Group finances its company using 40% debt and 60% equity with an equity beta of 1.16. The company has 55% of its current value related to higher risk projects. The risky projects have been estimated that they are 30% more risky than those of similar projects.
You are tasked to provide justifications whether the Company should invest in this project, with consideration of the company financial performance and the following information:
• Assume a corporation tax rate of 30% and the project is expected to generate 18% return.
• Given that the Company will finance its expansion by debt and equity finance, the new capital structure of the Company could be 50% debt and 50% equity.
• The return on Treasury bill is 4.5% and the market return is 11%.
Note: You are to critical evaluate the capital asset pricing model, discuss using asset beta in investment appraisal and analyse potential implications of the investment on the Company.
Answer-
1. Abbot plc
Ba normal – 65 %
Ba risky – 35 %
1.05=0.35*1.26+0.65*Ba_related
1.05=0.441+0.65*Ba_related
Ba_related = 0.94
2. Broadridge Inc
1.34 = Ba x [1 + D x (1-t)/e]
1.34=Ba x [1+ 0.30 X (1 -0.30)/0, 70] = 1, 3
1.34=Ba x 1.3
Ba_related= 1.03
3. Cecilia PLC
Ba= 1.20*(0.67/ (0.67+0.33 x (1 – 0.30)) =0.90
0.90 = (0.60*Ba) +(0.40*1.4)
Ba = 0.90/0.60+(0.40*1.4)
Ba_related = 0.76
4. Ecolab
Ba= 1.16*(0.60/ (0.60+0.40 x (1 – 0.30)) =0.79
0.79= (0.45*Ba) +(0.55*1.3)
Ba = 0.79/0.45+(0.55*1.3)
Ba_related = 0.68
Average Beta
0.94 +1.03+0.76+0.68/4=0.85
Financial risk consideration
Beta equity = 0.85 * ((0.50+0.50 * (1-0.30)/0.60)=
Be=Ba * [ 1 +D/E/ x (1-t)]
0.85 x [ 1 + 0.50/0.50 x (1-0.30)] =1.45
CAPM
CAPM = rf +b (rm-rf)
ra=4.5% + 1.45 (11%-4.5%)
ra= 9.7%
