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Hello Sir,
Thanks for the good work you doing. I am finding it difficult to grasp the asset beta concept.
If the asset beta measures the risk of a company taking out the debt element. Why then do we still add the debt beta to the equity beta portion in the asset beta formulae? Shouldn’t we rather be subtracting it. If we don’t assume debt beta to be nil, then doesn’t adding it as it is done in the formulae gearing the beta rather than ungearing it?
Shares are risky for two reasons – partly due to the nature of the business (some businesses are more risky that other businesses), and made more risky due to the gearing in the company.
The asset beta measures the risk of the business. The equity beta measures the risk of the share, which will always be greater if there is gearing in the business.
If you look carefully at the asset beta formula, then we are not actually adding the debt beta – we are effectively calculating an average of the equity and the debt betas. As a result the asset beta will always be lower than the equity beta (assuming that there is gearing).
I do assume that you have watched all of my lectures on this?
Yes I did watch them.
So if the asset beta is the risk of ungeared company meaning a company without debt, then what is the debt beta part of the asset beta formulae doing? Why do we have to add the average of the debt beta too?
Given that the equity beta will always be higher than the asset beta for the reasons I explained in my previous post, and given that the debt beta will always be pretty low (in theory, and in the exam it will be zero – in practice it won’t be zero but will still be low), then averaging the equity and debt betas will result in a beta somewhere in between the two. This will be the asset beta.
To say more would mean proving the formula, which I am certainly not going to do here because proving it is not required in the exam 🙂
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