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Total Risk

Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA FM Exams › Total Risk

  • This topic has 8 replies, 2 voices, and was last updated 3 years ago by John Moffat.
Viewing 9 posts - 1 through 9 (of 9 total)
  • Author
    Posts
  • May 27, 2022 at 9:50 pm #656661
    Anonymous
    Inactive
    • Topics: 29
    • Replies: 39
    • ☆☆

    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.

    May 27, 2022 at 10:18 pm #656666
    Anonymous
    Inactive
    • Topics: 29
    • Replies: 39
    • ☆☆

    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.

    May 28, 2022 at 7:49 am #656700
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 54699
    • ☆☆☆☆☆

    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).

    May 28, 2022 at 8:36 am #656709
    Anonymous
    Inactive
    • Topics: 29
    • Replies: 39
    • ☆☆

    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?

    May 28, 2022 at 1:51 pm #656722
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 54699
    • ☆☆☆☆☆

    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.

    May 28, 2022 at 5:11 pm #656735
    Anonymous
    Inactive
    • Topics: 29
    • Replies: 39
    • ☆☆

    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.

    May 29, 2022 at 7:30 am #656765
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 54699
    • ☆☆☆☆☆

    In Paper FM you use the current WACC to appraise investments, as I have explained.

    May 29, 2022 at 10:40 am #656778
    Anonymous
    Inactive
    • Topics: 29
    • Replies: 39
    • ☆☆

    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) ?

    May 29, 2022 at 3:28 pm #656797
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 54699
    • ☆☆☆☆☆

    It depends on what the question asks for!!

    If it is the WACC that is required then you calculate the current WACC and use that for appraisal.

    If it asks for the project specific cost of equity then you would calculate that (but cannot be expected to use it for appraisal).

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