long term debt issue

Understanding Total Risk of a share, Security, Project, Investment, etc.,

Quick Recap:

According to “M&M Theory”, the Total Risk of a share is made up of

Business Risk + Financial Risk

According to “Portfolio Theory”, the Total Risk of a share is made up of
Systematic Risk + Unsystematic Risk

According to “Portfolio Theory”, the Unsystematic Risk is “diversified away” or eliminated when a “well Diversified Portfolio” is held.

Put the two theories together and you get,

Total Risk = Systematic Business Risk + Systematic Financial Risk

A couple of conclusions:

(1) What determines the RETURN on a security is only the SYSTEMATIC RISK of the security … assuming the investors themselves hold well diversified portfolios. We call this systematic risk the BETA of the share.

(2) BETA measures the systematic risk of a share …. and this may comprise both systematic business risk and systematic financial risk.

(3) GEARED BETA reflects both systematic Business risk + systematic Financial risk

(4) Remove the FINANCIAL RISK and you are left with the UNGEARED BETA

(5) UNGEARED BETA reflects systematic business risk only.

(6) UNGEARED BETA = INDUSTRY BETA = ASSET BETA

(7) In the exam: The Observed Beta is usually a Company Beta which implies it must be an Equity Beta. (Why is that? Because Equity Betas are calculated, in the first place, from observing and analyzing, movements in the price of the company’s quoted share price).

(8) It follows therefore that if a company has debt in its capital structure, then the OBSERVED BETA (i.e the EQUITY BETA) must be a GEARED BETA

(9) If the company is ALL equity financed (there id no debt in the Capital Structure) then the EQUITY BETA (i.e the OBSERVED BETA) must be an UNGEARED BETA

(10) The final point to appreciate is that if you REMOVE the FINANCIAL RISK from the EQUITY BETA then you have to be left with the UNGEARED EQUITY BETA ie., the INDUSTRY or ASSET BETA.

Final Conclusion:

This is what questions in this area are all about …. Moving from a GEARED BETA to an UNGEARED BETA and then back to a revised GEARED BETA again …..

Thus, you will be determining BETAS that reflect the BUSINESS risk of a particular project (i.e the INDUSTRY in which it operates) …. which implies you need to find the UNGEARED BETA

and/or

also reflecting how the project is to be financed (i.e. say, with the same level of FINANCIAL risk as the company making the investment (same level of Capital Gearing as the company)…. which implies you need to find the GEARED BETA

Think about all I have said here and the underlying logic should become clear to you!
Regards, Kevin Kelly