Risk-free debt — OpenTuition Forums

AAl10y ago

Hi John I hope you are well and enjoying the summer. Please could you help understanding this statement "the consequence of making the assumption that debt is risk-free is that the formulae tend to overstate the financial risk in a feared company and to understate the business risk is geared and ungeared companies by a compensating amount." Many thanks

John MoffatTutor10y ago#1

If you look at the asset beta formula, then assuming that the debt beta is zero (risk free) means that the equity beta ends up higher (i.e. it overstates the financial risk). Also, assuming that the debt beta is zero means a lower asset beta - that is therefore understating the business risk.

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