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Hi,
we had assumed that the debt beta is zero in computing for asset beta/ungeared beta. meaning the debt is risk free and we are only left with the risk related to assets ignoring the effect of gearing(as ungeared in the formula). now in reality there will be risk attached to debt. so in this sense i thought assuming zero debt beta result in the equity beta and financial risks being understated. but this was marked wrong in practice question.i will appreciate explanation on this subject.
or to make it fit the other way round, i carry last part of the right side of the formula to same side as asset beta and assume the other side of the equation kBe ( keeping all other variables constant). end up with Ba-kBd= kBe. this way, assuming kBd zero is undoubtedly overstating kBe because the amount was ‘not fairly’ reduced as it would have been in real life. i think i am getting it…
thanks,john
Your second post has got it 🙂
The asset beta will stay the same whatever the level of gearing, and is equal to a weighted average of the equity beta and the debt beta (as in the asset beta formula).
If the debt beta is assumed to be zero then for the asset beta to stay the same then the equity beta will have to be higher (to keep the average the same).
So the equity beta is overstated.
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