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I have come across with a past year question regarding the beta of debt, it is stated that when assuming that the beta of debt is zero will actually overstate financial risk when ungearing an equity beta. I understand that in real life the debt beta is not zero, but I do not see how the zero debt beta will overstate the financial risk.
If you look at the asset beta formula, then rearranging it gives the following:
the term including the equity beta = the asset beta minus the term including the debt beta.
We assume in calculations that the debt beta is zero, which means that the term including the equity beta = the asset beta
However, if the debt beta is more than zero, then the term including the equity beta will be lower. It will equal the asset beta minus the term including the debt beta.
That will result in a lower equity beta.
So…..assuming a debt beta of zero results in a higher equity beta i.e. more financial risk.
I hope that makes sense 🙂
Letting the debt beta to become zero will surely overstate the finance risk when investing an equity beta instead of understating
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