Question

North Pole Fishing Equipment Corporation and South Pole Fishing Equipment Corporation would have identical equity betas of 1.10 if both were all equity financed. The market value information for each company is shown here: North Pole South PoleDebt $ 2,900,000 $ 3,800,000 Equity $ 3,800,000 $ 2,900,000 The expected return on the market portfolio is 10.9 percent, and the risk-free rate is 3.2 percent. Both companies are subject to a corporate tax rate of 35 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 final answers to 2 decimal places. (e.g., 32.16))Equity betaNorth Pole South Pole b. What is the required rate of return on each of the two companies’ equity? (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))Rate of returnNorth Pole % South Pole %

Answer 1

Answer and Explanation:

The calculation is given below;

For North Pole:

Unlevered Beta = 1.10

Debt = $2,900,000

Equity = $3,800,000

So,  

D/E Ratio = Debt ÷ Equity

=  $2,900,000 ÷ $3,800,000

= 0.76316

Now

Levered Beta = Unlevered Beta × [1 + (1 - tax) × D ÷ E Ratio]

= 1.10 ×  [1 + (1 - 0.35) × 0.76316]

= 1.65

Required Return = Risk-free Rate + Levered Beta × (Market Return - Risk-free Rate)

= 3.20% + 1.65 × (10.90% - 3.20%)

= 15.91%

For South Pole:

Unlevered Beta = 1.10

Debt = $3,800,000

Equity = $2,900,000

So,

D/E Ratio = Debt ÷ Equity

= $3,800,000 ÷ $2,900,000

= 1.31034

Now

Levered Beta = Unlevered Beta × [1 + (1 - tax) × D ÷ E Ratio]

=  1.10 × [1 + (1 - 0.35) × 1.31034]

= 2.04

And

Required Return = Risk-free Rate + Levered Beta × (Market Return - Risk-free Rate)

= 3.20% + 2.04 × (10.90% - 3.20%)

= 18.91%