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Dear Sir,
In question Tisa Co, part a, It can be assumed that 80% of Elfu Co’s debt finance and 75% of Elfu Co’s equity finance can be attributed to other activities excluding the component production. In the solution:
1.217 = component asset beta x 0.25 + 1.078 x 0.75
Why dont we use debt finance ratio (80%) in above calculation?
Thanks,
DTDebt only carries the risk of bankruptcy.
The risk we are normally concerned with is the potential fluctuations in the income stream. Dividends fluctuate, but debt interest is fixed interest and there carries zero risk (except, again, for the risk of bankruptcy in which case obviously there is no interest 🙂 )You should be aware from school, that writing something to the power of 1/2 is another way of writing that is the square root of 5 (it is easier for them to type!! 🙂 )
As to why we take the square root is explained in my free lectures on VaR.
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