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John Moffat.
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Joseph.Andrews
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There is a question Par Co (Sept 2016) But I am confused with option D. You said in your lecture that we always assume that Debt Beta is 0 Therefore, we do not take the debt beta formula part while calculating asset beta.
Which of the following statements relating to the capital asset pricing model is correct?
A. The equity beta of Par Co considers only business risk
B. The capital asset pricing model considers systematic risk and unsystematic risk
C. The equity beta of Par Co indicates that the company is more risky than the market as a whole
D. The debt beta of Par Co is zero
John Moffat
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There was no question called Par in the September 2016 exam and so it is impossible for me to give a precise answer (because there was obviously more data given in the question).
CAPM does not assume that the debt beta is 0. In practice, debt betas are not 0. They will be small, but debt does carry some risk, whereas a beta of 0 would mean that it was completely risk free.
You can see from the asset beta formula that we can deal with whatever debt beta there is – it is just that in exam questions we always assume it to be zero when using the formula.
I am guessing that in the question you refer to that the return on debt is great than the risk free rate. If so, then the debt beta is certainly not 0.
Joseph.Andrews
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Sir, It is a Section B question [Q16-20] in Sept 2016 Specimen Exam. Here is the link for that – https://www.accaglobal.com/content/dam/acca/global/PDF-students/acca/f9/specimen/f9-specimen-s16.pdf
John Moffat
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I was looking at the actual September 2016 exam – you had not said that you were referring to the specimen exam 🙂
However my answer remains the same in that CAPM does not assume that debt has a beta of zero for the reasons I explained.
Joseph.Andrews
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Thanks Sir. I appreciate your time & efforts. 🙂
Plz Correct me here also!
Debt beta is 0 when calculating Asset Beta as u said BUT in practice, “if the company has some debt borrowing then there must be some debt beta if they are geared” such as in the case of Par Co which has convertible loan notes & Bank loans debts. True?
John Moffat
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That is not quite what I said 🙂
If debt is not risk free then the beta of debt is not zero. In practice debt is not risk free (even though the risk will be small) and so the debt beta will be small but will be more than 0.
CAPM theory does not assume that the debt beta is zero. (The asset beta formula includes using the debt beta, and it is only for exams that we assume a debt beta of zero when using the formula to keep things easier. If we were using the formula in real life then we certainly would not assume a debt beta of zero.)
Joseph.Andrews
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