Claxby is an undiversified company operating in light engineering. It is all-equity financed with a Beta of

Question:

Claxby is an undiversified company operating in light engineering. It is all-equity financed with a Beta of 0.6. Total risk is 40 (standard deviation of annual return). Management want to diversify by acquiring Sloothby Ltd, which operates in an industrial sector where the average equity Beta is 1.2 and the average gearing (debt to total capital) ratio is 1:3. The standard deviation of the return on equity (on a book value basis) for Sloothby is 25 per cent. The acquisition would increase Claxby's asset base by 40 per cent. The overall return on the market portfolio is expected to be 18 per cent and the current return on risk-free assets is 11 per cent. The standard deviation of the return on the market portfolio is 10 per cent. The rate of corporation tax is 33 per cent.

(a) What is the asset Beta for Sloothby?

(b) Analyse both Sloothby's and Claxby's total risk into their respective specific and market risk components.

(d) Using the new Beta, calculate the required return on the expanded firm's equity. Under what conditions could this be taken as the cut-off rate for new investment projects?

(e) In the light of the figures in this example, discuss whether the acquisition of Sloothby may be expected to operate in the best interests of Claxby's shareholders.

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