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i have been searching the answer.i don’t know what means of beta debt.what is the benchmark it compared to?.I need deeper explaination on this.
Its call debt beta. Debt is risk free campare to equity investment. So it is assume to zero to calculate asset beta.
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Debt beta is assumed to be zero when there is nothing mentioned in the question for diversification (if it is risk free)
If it is not risk free, it has some valuebeta represents systematic risk..a risk which cannot be diversified and the company has to face…and debt beta means systematic risk of debt..if debt beta is zero it means our debt is risk free and if it has a value then it means its not risk free.
Sorry Izzuan, I am late to reply to your post, the reason of debt beta being zero is that Interest on debt capital doesn’t vary for example when a company issues debt for its expansion project it has to pay interest to the debenture holders yearly at a fixed rate and this rate doesn’t change irrespective of Economic conditions therefore there is no volatility in the interest rate and when there is no volatility obviously the risk which is calculated in quantitative terms which is called as Standard deviation is Zero. Since beta is also a measure of risk even the beta tends to become zero. However a Company’s Equity Beta changes according to the changes in the economic conditions of the country which reflected on the Stock Index and as the company’s stock is also correlated to the Stock Index the Beta of the stock changes unless your stock is perfectly correlated with the Stock Index which is less practical. And as the beta changes Investors or the Stake holders expect their rate of returns in accordance with the changes in the beta and as a result there will be change in the Cost of Equity of the company (Ke). I am sure your well versed with the CAPM model figured out by Harry Markowitz Ke=RF+Beta(RM-RF). To conclude Debt capital cost (Kd) is not volatile and hence the debt beta is always Zero However the Cost of Equity (Ke) changes according to the Stock Index movements and hence Equity Beta varies. Hope this was helpful. Thank You:)
Two corrections to add to the above:
Firstly, although in the exam we always assume the debt beta to be zero, in practice it is not zero (although it would be low). That is why it is included in the asset beta formula on the formula sheet even though (again) we always ignore that part in the exam because we assume it to be zero.
There are two reasons why it is not always zero in practice. One is because there is always the possibility of the company not being able to pay the interest, and therefore risk does exist. The other is that although the coupon rate may be fixed, Kd (the investors required rate of return) does change. The rate required by investors will vary with general interest rates.Secondly, it is not the case that a company’s equity beta changes with the economic climate. We would expect a companies beta to remain constant (unless the nature of the business changes). The return required by shareholders (and therefore the cost of equity) will change as the overall return on the stock exchange changes. Beta measures the rate of change relative to the stock market as a whole.
Thank you John, This was very helpful know I have a better conceptual clarity now.
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Thanks John
Dear John,
In the BPP studytext, Practice Answer Bank, for the question of Canadian Inc:
There is a debt beta of 0.25. And the Kd is obtained using CAPM
ie KD= 8% + (16% – 8%) 0.25= 10%.I thought the CAPM can only be used to calculate Ke? Hoping you could clarify. Thx
In future you must ask in the Ask the Tutor Forum if you want me to answer – this forum is for students to help each other.
CAPM is relevant to any securities – whether it is equity or debt.
Usually we assume debt to be risk free in which case the beta is 0. However, in practice it is not risk free, therefore will have a beta (albeit low, because the risk is low compared with that of equity), and the beta will determine the required return as usual.
Sir, may I know why we assumes the debt beta to zero will overstate the financial risk but not understate the risk?if debt beta is zero means it is risk free right?but how come it is risk free but will overstate the financial risk?
Financial risk is the risk due to the gearing and it is shareholders who suffer financial risk.
If you look at the asset beta formula, if we assume that the debt beta is zero then the first term (with the equity beta in it) will be equal to the asset beta.
If on the other hand we have a debt beta of more than zero, then the asset beta will not change and so the term including the equity beta will be lower. So the equity beta will be lower.
So…..assuming a debt beta of zero means a higher equity beta due to the financial risk and this is overstating the financial risk.
This is actually a Paper FM question – I cannot see the question being asked in Paper AFM.
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