Capital Structure Theories^285Cost of Equity and Beta of a Division
It has been argued that in evaluating a divisionís investment, its cost of capital should
be used as the discount rate. The risk of the division may not be the same as the risk
of the firm. The beta of the division may, therefore, be higher or lower than the firmís
beta. We also explained that in practice, a divisionís beta may be approximated by
finding out the betas of the comparable firms in the same industry to which division
belongs. However, the comparable firms may have different levels of debt. Before
using the beta of a comparable firm (or weighted average betas of the comparable
firms) to a division, adjustment for leverage should be made. The following steps are
involved:
l Identify comparable firms in the same industry as the division.
l Calculate the betas of the comparable firm.
l Estimate the comparable firms asset betas by adjusting them for leverage and
tax. (This process is called ëunleveringí the beta) ,
l Calculate the average beta from the comparable firmsí asset betas that can be
used as the beta for the division,
Illustration 10: A large engineering company wants to diversify into fertiliser business
organise it as a new division. The company found a comparable fertiliser company that
has an equity beta of 1.35, and debt ratio of 0.72. The corporate tax rate is 35 per cent.
The engineering company will have a debt ratio of 0.50 for proposed fertiliser business.
Calculate the beta for the proposed new division.
First, we shall ëunleverí the equity beta (that is, calculate the asset beta) of the
comparable firm:ba = be
^
$ $ =
- ¥
= -
Second, se can now ëleverí the equity beta for the division by incorporating its debt
ratio:be = ba
^
^ ^
$ $ = ¥ =
= - ¥
The equity beta for the division is lower than that of the comparable firm since it will
employ less debt.
Adjusted Present Value
Equation (14) gives the value of a levered firm:Vl = Vu + TD =
-+
...(14)