Can we say these?
1. The total systematic risk of the share is 1.8 times the market premium:
1a. Part of this risk is due to business risk of 1.4 times the market premium and
1b. Part of this risk is due to financial risk of 0.39 times the market premium.

No – you cannot say that (and you would not be asked to anyway).

Gearing risk does not exist on its own. If the profits before interest were fixed (i.e. certain and no risk) then there would not be any extra risk because of gearing.
What gearing does is amplify (or increase) whatever the gearing risk is.
Expressing it as a % is a neat idea, but it would not be correct.

I am just curious though. Assuming there is risk for debt therefore debt beta do exist, why do we have to add that to the equity beta in the formula to get the asset beta since what we after is the asset beta (beta without debt ie ungeared beta)?

In a sense the equity and the debt “share” the risk of the business. So the business risk (measured by the asset beta) is the weighted average of the equity and debt betas (and is therefore always going to be lower than the equity beta).

I wonder if you could help me with what currently seems a riddle to me.

At the end of the lecture you use the ungearing formula without the debt beta section, to get the lower betas for the ungeared company.
The reason for leaving out the debt beta section is given as debt beta is effectively zero, but then the beta of the ungeared company is lower, is this difference in the betas of equity and asset not just the debt beta as the only thing that has been removed is the gearing which is necessarily debt ?

Thanks in advance for your answer, (even if its just forget about this point and use the formula)

The equity beta is the risk of the shares, and part of the reason it is risky is because of the level of gearing.

The asset beta measure the risk if there was no gearing.

Even if the beta of debt was not zero, it would still be lower than the beta of the equity (because debt is always less risky that equity) and the asset beta would be lower than the debt beta.

a) when you say the debt to equity ratio is 0.2 wouldn’t this mean 20% of debt out of %100 capital? and therefore would it not be 20 to 80? instead of 100 to 20?

b) when taking account of the gearing in the Beta, in this example you used 100 as value for equity, however if the figure was expressed as a percentage would this formula still work?

Gearing can be expressed in two way (and the question will always tell you which way).

Debt to equity of 0.2 means that debt is 0.2 x equity. i.i. for 100 equity, 20 debt.

The alternative is debt to total long-term finance (debt + equity) and in that case it would be 30 debt to 80 equity.

You can use any numbers, provided the ratio is the same, and you will get the same answer. E.g. use 20 and 100, or use 40 and 200. It will be the same answer.

No – there are two different ratios. Either debt/equity or debt/(equity+debt). The question will always tell you which of the two gearing ratios to use.

Regearing the beta is calculating the equity beta by using the asset beta formula backwards. It is covered in this lecture that you are commenting on.

I’m having a problem playing this lecture, I’ve tried it on numerous devices (and in my dad’s!) for a few days now and it still stops after the intro.
I’ve never had a problem playing any other lectures before or since.
Is anybody else able to play it?

When we know the asset beta for the project (by ungearing the equity beta of a company is the same sort of business), we then regear it for the project based on the gearing of the project. Unless we are told different we assume that the project will be financed in the same gearing ratio as the current gearing of the company.

I would just like to say thanks a million for posting these lectures. You’re a brilliant lecturer and simplify topics so that the viewer understands how the formulae work, which enables one to reason things out rather than just memorise and hope for the best. Brilliant work and thank you for making our lives easier 🙂

Thank you for the lectures, they have been a really big help.
If we are not accepting the beta printed in the papers and are using this formula to remove the gearing risk, why are we saying that the debt beta is zero?
Isn’t the debt beta the gearing risk in the “paper” beta?
Where did I go wrong?
Thanks.

The debt beta measures the riskiness of the debt (just as the equity beta measures the risk of the shares). We usually assume that debt is risk free and therefore has a beta of zero, but in practice debt does carry some risk and will therefore have a beta (albeit we would expect it to be low).

Published betas are the betas of shares (the equity beta). This measure the total riskiness which is caused by the risk of the business together with the fact that more gearing makes them more risky.

Hi Mr Moffat, i just have small question once again,,as you said , Beta is the level of risk of an investment relative to the market (stock exchange average), this focuses specifically on the systematic risk, assuming the shareholders hold diversified shares which eliminate or rather deal with the unsystematic risk by themselves,, my question is as u said the beta is partly affected by the level of gearing,, in which the gearing is unsystematic risk in which we have assumed to be eliminated,,so how come the beta have both an element of systematic and unsystematic risk?

I sincerely appreciate for the awesome lectures and for the quick response you normally respond from the earlier questions,, thanks once again.

Gearing is not risk that can be measured in its own right. If profits before interest were certain (no risk) then the dividends would also be certain (no risk).

What gearing does (because of the fixed interest) is make the existing risk (due to the profits being risky) greater.

We are only interested in systematic risk (for the reasons you state above), but if there is gearing then this risk will be increased for shareholders because of the fixed interest, and therefore the equity beta will be higher.

Gearing is not unsystematic risk – unsystematic risk is due to factors specific to the company (e.g. new management makes things more risky). Gearing makes this risk bigger as well, but we are not interested in unsystematic risk.

(If my explanation of why gearing makes the existing risk bigger confuses you at all, then you will find a lecture here for F9 explaining how gearing makes the risk bigger, with a few simple numbers)

Simply made simple. I just wonder why we must do the Asset beta calculations when we can tell just by looking at the two beta of shares which have been given that P plc has a higher beta thus more risky.

The share with the higher beta is certainly the more risky share.

However, shares are risky for two reasons – partly because of the riskiness of the business and partly because of the way the business is financed (the level of gearing).

The equity beta measures the riskiness of the share, but the asset beta takes out the effect of the gearing and measures the riskiness of the actual business. The question in the lecture asks for two things – which share is the more risky, and secondly which is the more risky business. The only way you can answer the second question it to remove the gearing effect by calculating the asset beta, and then comparing the two. Since the level of gearing in the two companies is different, there is no way of finding out which is the more risky business without calculating the asset beta.

Thanks, i think i did not realize how different the two questions are. so simple how we fail exams!!!
Then i get the conclusion that a company would have more risky shares yet lessor risky business activity right? just that coincidentally P plc happens to be the more risky share as well as having the more risky business activity.

Salman says

Dear sir,

In example 1 for P plc.

Can we say these?

1. The total systematic risk of the share is 1.8 times the market premium:

1a. Part of this risk is due to business risk of 1.4 times the market premium and

1b. Part of this risk is due to financial risk of 0.39 times the market premium.

Thanks,

John Moffat says

1 and 1a are correct.

1b is not correct – gearing multiplies the risk, it is not something that can be measured separately and ‘added on’.

Salman says

Dear sir,

Ok. Can I say that the 0.39 as a percentage of 1.8 => 21.6% is due to financial risk?

Thanks,

John Moffat says

No – you cannot say that (and you would not be asked to anyway).

Gearing risk does not exist on its own. If the profits before interest were fixed (i.e. certain and no risk) then there would not be any extra risk because of gearing.

What gearing does is amplify (or increase) whatever the gearing risk is.

Expressing it as a % is a neat idea, but it would not be correct.

Ernest says

Thanks for the great lecture!

I am just curious though. Assuming there is risk for debt therefore debt beta do exist, why do we have to add that to the equity beta in the formula to get the asset beta since what we after is the asset beta (beta without debt ie ungeared beta)?

John Moffat says

Thank you for the comment.

In a sense the equity and the debt “share” the risk of the business. So the business risk (measured by the asset beta) is the weighted average of the equity and debt betas (and is therefore always going to be lower than the equity beta).

Ernest says

Thank you.

John Moffat says

You are welcome 🙂

John says

Hi,

I wonder if you could help me with what currently seems a riddle to me.

At the end of the lecture you use the ungearing formula without the debt beta section, to get the lower betas for the ungeared company.

The reason for leaving out the debt beta section is given as debt beta is effectively zero, but then the beta of the ungeared company is lower, is this difference in the betas of equity and asset not just the debt beta as the only thing that has been removed is the gearing which is necessarily debt ?

Thanks in advance for your answer, (even if its just forget about this point and use the formula)

Best regards

John

John Moffat says

The equity beta is the risk of the shares, and part of the reason it is risky is because of the level of gearing.

The asset beta measure the risk if there was no gearing.

Even if the beta of debt was not zero, it would still be lower than the beta of the equity (because debt is always less risky that equity) and the asset beta would be lower than the debt beta.

John says

Thank you for this explaination, I was not distinguishing between debt and gearing properly, thanks again, John

brenda1 says

Halo Sir, please kindly explain to me the word “gearing”. I think Im not understanding it well

Thanks

fahim231 says

hello sir

great lecture…….just a couple of questions

a) when you say the debt to equity ratio is 0.2 wouldn’t this mean 20% of debt out of %100 capital? and therefore would it not be 20 to 80? instead of 100 to 20?

b) when taking account of the gearing in the Beta, in this example you used 100 as value for equity, however if the figure was expressed as a percentage would this formula still work?

thanks

John Moffat says

Gearing can be expressed in two way (and the question will always tell you which way).

Debt to equity of 0.2 means that debt is 0.2 x equity. i.i. for 100 equity, 20 debt.

The alternative is debt to total long-term finance (debt + equity) and in that case it would be 30 debt to 80 equity.

You can use any numbers, provided the ratio is the same, and you will get the same answer. E.g. use 20 and 100, or use 40 and 200. It will be the same answer.

fahim231 says

so regarding the alternative debt to equity, how would 0.2 debt get you 30 debt to 80 equity?

John Moffat says

Sorry – I mistyped. I meant to write 20 debt to 80 equity (so debit is 0.2 times total long-term capital).

fahim231 says

oh i see, so their both the same ratio but just expressed in a different way?

One more thing sir can you please tell me how to re gear ? or point me to a lecture where you cover this? if you do cover this?

John Moffat says

No – there are two different ratios. Either debt/equity or debt/(equity+debt). The question will always tell you which of the two gearing ratios to use.

Regearing the beta is calculating the equity beta by using the asset beta formula backwards. It is covered in this lecture that you are commenting on.

fahim231 says

I thought what we were doing this lecture was called de gearing?

John Moffat says

But this is only part (b) of the lecture. Finish the lecture by watching part(c) of it as well!

Michael says

I’m having a problem playing this lecture, I’ve tried it on numerous devices (and in my dad’s!) for a few days now and it still stops after the intro.

I’ve never had a problem playing any other lectures before or since.

Is anybody else able to play it?

rayhaankhambiye says

Sir i am in trouble once again when do we regear the company 🙁

John Moffat says

We don’t regear the company.

When we know the asset beta for the project (by ungearing the equity beta of a company is the same sort of business), we then regear it for the project based on the gearing of the project. Unless we are told different we assume that the project will be financed in the same gearing ratio as the current gearing of the company.

cormac says

Thank you John. All your lectures are excellent. You are a great teacher!

sherese22 says

I would just like to say thanks a million for posting these lectures. You’re a brilliant lecturer and simplify topics so that the viewer understands how the formulae work, which enables one to reason things out rather than just memorise and hope for the best. Brilliant work and thank you for making our lives easier 🙂

John Moffat says

Thank you very much, and good luck in the exams 🙂

Shimon says

Thank you for the lectures, they have been a really big help.

If we are not accepting the beta printed in the papers and are using this formula to remove the gearing risk, why are we saying that the debt beta is zero?

Isn’t the debt beta the gearing risk in the “paper” beta?

Where did I go wrong?

Thanks.

John Moffat says

The debt beta measures the riskiness of the debt (just as the equity beta measures the risk of the shares). We usually assume that debt is risk free and therefore has a beta of zero, but in practice debt does carry some risk and will therefore have a beta (albeit we would expect it to be low).

Published betas are the betas of shares (the equity beta). This measure the total riskiness which is caused by the risk of the business together with the fact that more gearing makes them more risky.

SOUD SAEED says

Hi Mr Moffat, i just have small question once again,,as you said , Beta is the level of risk of an investment relative to the market (stock exchange average), this focuses specifically on the systematic risk, assuming the shareholders hold diversified shares which eliminate or rather deal with the unsystematic risk by themselves,, my question is as u said the beta is partly affected by the level of gearing,, in which the gearing is unsystematic risk in which we have assumed to be eliminated,,so how come the beta have both an element of systematic and unsystematic risk?

I sincerely appreciate for the awesome lectures and for the quick response you normally respond from the earlier questions,, thanks once again.

John Moffat says

Gearing is not risk that can be measured in its own right. If profits before interest were certain (no risk) then the dividends would also be certain (no risk).

What gearing does (because of the fixed interest) is make the existing risk (due to the profits being risky) greater.

We are only interested in systematic risk (for the reasons you state above), but if there is gearing then this risk will be increased for shareholders because of the fixed interest, and therefore the equity beta will be higher.

Gearing is not unsystematic risk – unsystematic risk is due to factors specific to the company (e.g. new management makes things more risky). Gearing makes this risk bigger as well, but we are not interested in unsystematic risk.

(If my explanation of why gearing makes the existing risk bigger confuses you at all, then you will find a lecture here for F9 explaining how gearing makes the risk bigger, with a few simple numbers)

Yama says

Hi John,

I have a quick question on example 1 page 114. P plc gearing ratio 0.4

We took the following:

Equity 100

Debt 40

I’m just confused why we didn’t take:

Equity 60

Debt 40

John Moffat says

The gearing was defined in the question as being debt to equity – so for every 100 equity there is 40 debt.

lydiaw says

Hi John,

I have a quick question on example 1 page 114. P plc gearing ratio 0.4

We took the following:

Equity 100

Debt 40

I’m just confused why we didn’t take:

Equity 60

Debt 40

Sorry if I’ve missed something obvious but if you could clarify for me.

Thanks in advance

Lydia

308002873 says

This is the same thing i’m confused about too. i understand everything else but that equity 100 / debt 40 i just don’t get.

Yando says

Simply made simple. I just wonder why we must do the Asset beta calculations when we can tell just by looking at the two beta of shares which have been given that P plc has a higher beta thus more risky.

John Moffat says

The share with the higher beta is certainly the more risky share.

However, shares are risky for two reasons – partly because of the riskiness of the business and partly because of the way the business is financed (the level of gearing).

The equity beta measures the riskiness of the share, but the asset beta takes out the effect of the gearing and measures the riskiness of the actual business. The question in the lecture asks for two things – which share is the more risky, and secondly which is the more risky business. The only way you can answer the second question it to remove the gearing effect by calculating the asset beta, and then comparing the two. Since the level of gearing in the two companies is different, there is no way of finding out which is the more risky business without calculating the asset beta.

Yando says

Thanks, i think i did not realize how different the two questions are. so simple how we fail exams!!!

Then i get the conclusion that a company would have more risky shares yet lessor risky business activity right? just that coincidentally P plc happens to be the more risky share as well as having the more risky business activity.

jeweltrinidad says

Thanks John, really brought a simple understanding. Great Lecture.

manvilles says

thank you totally get it

mahongo says

The lecture is really good .. thanks John and OT!!!!

temi says

you are simply the best John, is it only f9 you take

tatipast says

this is the best teacher I have ever, ever listen, thank you so much 10+

Saad Bin Aziz says

wow . that was one hell of a lecture! thanks john! you should write a book you know!