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FM Chapter 21 Questions – CAPM and MM combined

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  1. One of the assumptions of CAPM is debt is risk free. But QN 25 on your mock it says CAPM debt does not assume debt is risk free (although we do normally assume it is risk free when using asset beta formula).

    Please explain

    From kaplan text “unrestricted borrowing or lending at the risk-free rate of interest”

  2. Kindly explain why in question 5 the answer is not 13% but rather 27%?
    I realized the project specific cost of equity formula in the solution did not subtract the risk free (7%) from the premium rate (10%) in arriving at the answer of 27%.

    • Because using a beta of zero assumes that the debt has zero risk. In practice debt does carry some risk, therefore the beta of debt will be more than 1, and the fact that debt is risky in practice means there is more financial risk than when its beta is zero.

      • If you look at the asset beta formula, the asset beta is the weighted average of the equity beta and the debt beta.

        The asset beta is not affected by the gearing – if the gearing changes or the debt beta changes then it is the equity beta that changes.

        We assume that the debt beta is 0 in calculations, but in practice it will be small but will be greater than zero. For the asset beta to remain unchanged (as it will) if the debt beta is greater than zero then the equity beta will be smaller. So assuming 0 will overstate the equity beta and overstate the financial risk.

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