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Shareholders bears both financial and business risks, hence the premium for both risks is included in the cost of equity.
Do debt holders bear both business and financial risks (or only financial risk)?
They are at risk from both!
The riskiness of the business and the level of existing gearing in the business will be factors in lenders deciding what rate of interest to charge, and in suppliers deciding whether or not to offer credit.
(For the exam, be prepared to write that if the question asks you to discuss it. However you cannot be asked any calculations relating to this.)
Does the second bracket on the right hand side Asset Beta Formula
[ Vd (1-T) * ßd / Ve + Vd(1 – T) ] removes the financial risk from the debt beta (so the debt beta only includes business risk)?No – not at all!
Debt lenders do not have any financial (gearing risk) – they are not bothered by the level of gearing because they get their interest first.
The only risk that they are subject to is the business risk – the risk that profits will fall such that the company cannot pay the fixed interest that they are entitled to.
This risk is small – debt betas are always very low.
In the exam we always assume the debt beta to be zero (unless specifically told otherwise, which is unlikely) and so this part of the formula disappears.When there is a debt beta, the formula is effectively calculating a weighted average of the equity beta and the debt beta.
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