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Dear Sir,
In the solution for part b, There is para “The consequence of making the assumption that debt is risk free is that the formulae tend to overstate the financial risk in a geared company and to understate the business risk in geared and ungeared companies by a compensating amount”
I understand when there is financial risk, even small but we assume debt is risk free it be we assume less risk or understate the financial risk. and what does it mean “to understate the business risk in geared and ungeared companies by a compensating amount”
Thanks,
DTThe beta of the equity (the geared beta) is a measure of the total risk of the share – the business risk and the financial risk.
If debt is not completely risk free (which it is not in practice) then the beta of debt will be greater than zero.
if you put a figure in the formula for the beta of debt, then when you calculate the asset beta you will end up with a higher asset beta (the measure of business risk). By assuming the debt beta is zero we therefore end up understating the business risk.
If you are using the formula ‘backwards’ to calculate the equity beta when we know the asset beta, then have a debit beta great that zero will end up giving a lower equity beta than when assuming it is zero. Therefore assuming a debt beta of zero overstates the financial risk.
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