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.

anubhutityagi says

Got 100%

Thank you for the lectures.

John Moffat says

Thank you for your comment 🙂

fengsuiting says

Dear sir. Question 1, why assuming that beta of debt is 0 will understate financial risk when ungearing an equity beta is false?

John Moffat says

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.

Frooti says

Please explain question 1 3 statement , im confused

John Moffat says

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.

Ainul Asyikin says

Hello sir , does it mean that be in ke=rf+be(risk premium)

is business risk and financial risk that are not controllable since be only contain systematic risk?

Thanks in advance

John Moffat says

True, but all of this is explained in my free lectures on CAPM. Have you not watched them?