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Sir, is total risk = business risk + financial risk or systematic + unsystematic risk? I keep seeing this contradiction in questions where they refer to total risk sometimes as the former and sometimes as the latter.
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And also is the equity beta the systematic risk of the project + existing gearing of the company OR the gearing of finance raised specific for the project? I remember in the lectures you said we treat this projects as a different entity than the company.
Systematic risk is risk due to the nature of the business compared with the market as a whole. If there is gearing then this increases the systematic risk. (It isn’t ‘added on’ but multiplies the existing systematic risk).
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1. So let me understand this. Say a company currently has value of equity of 500 and debt of 250 so the existing gearing is 0.5. And the existing systematic risk of the company’s current operations is 1.5. They want to do a new project that’s different from current ops and has systematic risk of 2. They need $50. So does that mean the cost of NEW finance(ignoring the current WACC) is one that incorporates the systematic risk of 2 multiplied by the 0.5 or the gearing of NEW finance alone or 0.5+the ratio of new finance?
2. Isn’t systematic risk and financial risk mutually exclusive?
1. This cannot be asked in Paper FM (only in AFM). In Paper FM you can only be asked for the project specific cost of equity as explained in the lectures.
2. Yes, but just as gearing serves to increase the beta of a share it also serves to increase the systematic risk of the share.
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So what if the question gives us the equity beta of a company with the current gearing ratio. And then says they are planning to issue more debt. Calculate the WACC.
In Paper FM you use the current WACC to appraise investments, as I have explained.
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What I mean is say they gave us an equity beta and current gearing. And they gave us a risk premium and risk free return. Then they proceed to say they are issuing debt of 90m. Do we have to calculate a new equity beta(including the 90m) to calculate the cost of equity or do we just calculate it straight using the risk free + (Equity beta X premium) ?
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