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.
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Dear John,
I am a bit confused on why we need to ungear the equity beta(Be) of a share if the beta of debt (Bd) i.e. the 2nd part of the ungearing formula {(ve+vd (1-T) /vd(1-T)}Bd is zero considered to be zero. For me, there is nothing that needs to be ungeared as the geared portion of the equation is cancelled out from the ungearing formula.
Instead, the assumption that debt is risk free (even if,in real life, it’s not due to the default risk) should have lead us to assume asset beta(Ba) to equal to equity beta(Be) – not the other way round. Because since the 2nd part of the ungearing formula {(ve+vd (1-T) /vd(1-T)}Bd is assumed to be zero this then should sensibly lead us to assume that the company as a whole is financed by shareholders funds.
Can you please explain this please?Have you watched my free lectures on this?
More gearing always creates more risk for the shareholders (regardless of whether or not the debt itself it risk free). Therefore the equity beta (which is the riskiness of the shares including the effect of gearing) is always more than the asset beta (which is the riskiness if there was no gearing). The equity beta and the asset beta are only ever the same if there is no gearing in the company.
I do suggest that you watch the lectures (and if necessary the relevant Paper F9 lectures, because this is revision of F9 and also I explain exactly why gearing creates more risk for shareholders (because of the fixed interest payable on debt)).
Why on earth should assuming the the beta of debt is zero (i.e. that debt is risk free) lead us to assume that the company is entirely equity financed??? There is no logic to this at all – if the company was entirely equity financed then Vd would be zero and using the formula would be completely unnecessary.
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Thanks a lot!
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