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When we invest in new project and if it increases the financial risk of overall firm, what will be its impact on existing cost of capital?
If only the financial risk is increased (i.e. there is more gearing) then the WACC will fall (assuming there is tax and therefore there is tax relief on the interest).
However, this is assuming that the project itself has the same business risk as the existing company. If the risk of the project itself is different then this will affect the cost of capital.
More likely, both factors will change – the project will have a different level of business risk, and the method of financing will change the level of gearing.
thanks John for your reply. But i would like to discuss further about it.
suppose a firm has existing project whose asset beta is 1.2 and is planning to invest in project of same business risk but as it plans to finance by debt issue, it would raise its gearing level from 60%(existing debt:equity) to 90 %(after investment debt:equity). Now will this increase in financial risk concern shareholders and increase their expected required return? if yes does this mean existing asset beta would be changed? I would be thankful if you could explain with illustration.- Topics: 0
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Yes, financial risk will increase and make the cost of equity increase. If the cost of equity increase, the asset beta will change.
Look at CAPM formula, Ke = rf + rp * beta
Any change in beta will reflect cost of equity and vice versa- Topics: 0
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Asset beta means the beta at all-equity finance. The one will change with the financing side-effect is the equity beta.
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can u tel me on what factor basis risk depend and what it exactly means?
how business risk is calculated and how can all companies in same industries can have same business risk…as far as i know business risk include(operational, compliance,financial)…
how equity beta calculation is done…?- Topics: 0
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The business risk is the risk a company exposes itself to due to its nature of business. The business risk of every sector is different as there are inherent risk in each and every business for eg. the business risk of a departmental chain are different from that of a company operating in the textile sector. Asset Beta denotes the Business risk which cannot be diversified as it is the risk of that particular business; the whole sector will be effected by it for eg shortage of raw material, export duties etc. The equity beta is the risk of a company and it can be diversified.
Beta asset = Beta Equity x (Equity/equity + debt (1-t))
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When beta asset is calclated the capital structure is that of the industry while when ur calculating the beta equity then u put the capital structure of your own company.
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capm is measure of systematic risk…and in it we use systematic risk which is equity beta and systematic risk can not be diversified….and you are saying that equity beta can be diversified…
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capm is measure of sytematic risk…and in it we use systematic risk which is equity beta and systematic risk can not be diversified….and you are saying that equity beta can be diversified…
If shareholders have well-diversified portfolio why should they be concerned about company’s specific risk that is finance risk?
Why equity beta is used in CAPM instead of using asset beta to calculate cost of equity?- Topics: 0
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CAPM assumes that the share holders are well diversified. The cost of diversification for the company is much more expensive in comparison to a share holder.
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No matter how well diversified you are, u will require a higher return for a risky investment.
Beta Equity incorporates the beta asset in its calculation.
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Beta Asset is the ungeared beta while Beta Equity is the geared beta.
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