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Debt Beta and debt are not assumed to be risk-free!!
Please I came across a question that has debt beta. It is strange to me. I would appreciate more clarification.
QUESTION.
The following is extracted from the books of Carrimore PLC.Ordinary share at 50cent per share $20,000
Reserves $32,500
10% Debenture $15,000
________
$67,500
___________The Beta of the company asset is 0.763, while that of the debt is 0.2. The return on government security is 12%. The return on the market is 17%. Ordinary shares are currently quoted at $2.17 per share, while the market value of the debenture is $89.50 ex-interest.
Required: Using CPM, determine the company’s appropriate cost of capital. Assuming tax is 30%
Debt will not be risk free, but will have low risk and will therefore have a low beta (as is the case in this question).
It is only when using the asset beta formula in the exam that we always assume the debt to be risk free and therefore a debt beta of zero.
This question is clearly not a past exam question, but you will need to use the full asset beta formula (with a debt beta equal to 0.2) in order to calculate the equity beta.
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