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What is the difference between financial risk & business risk and which one is the ungeared & geared beta when it comes to the project-specific cost of capital (Asset Beta & Equity Beta)???
It would seem that you are not watching my free lectures where all of this is explained, and you cannot expect me to type out my lectures in full here!
Business risk is the risk due to the nature of the business – some types of business are more risky than other types of business.
Financial risk is the additional risk due to the level of gearing in the business – the more the gearing, the more the fixed interest is payable, and therefore the more risk to the shareholders.
The ungeared/asset beta is measuring the business risk in the company. The geared/equity beta is measuring the total risk of the shares. The more the gearing, then the more the risk to shareholders and therefore the higher will be the equity beta.
Again, all of this is explained in detail in my free lectures. The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
Hello Sir, I have seen your lecture on this topic again n again AND,
I wanted to ask that when we calculate project-specific cost of capital to calculate Asset Beta we need to take the data of Ungeared Company [Ungeared means company which has no debt BUT in example 2 of Chapter 21 we can clearly see that Company Y has 0.2 debt to equity which you take as 20 in your lecture which is fine BUT it clearly does not make sense to USE this company’s data because this company is geared]
[Doubt #1]
Why do we UNGEAR proxy company EQUITY BETA? To remove the debt part from the equity beta of proxy company?[Doubt #2]
Secondly, when we calculate Equity Beta we’ve to incorporate data of only the Regeared Company such as X Company BUT I don’t get the logic behind using Ungeared Company Asset Beta to Regeared Company Equity Beta.Why do we REGEAR Asset BETA? To add the debt part of our company into the formula?
The equity beta measures the risk of the shares which is due to both the business risk and the extra risk due to the gearing.
The purpose of the asset beta formula is to remove the effect of the gearing and the asset beta is therefore a measure purely of the risk of the type of business.
It therefore makes perfect sense to find a company in the same type of business, but if it is a geared company then to use the formula to remove the effect of the gearing from its equity beta in order to get the asset beta i.e. the measure of the risk if there was no gearing.
Good day sir, i have a doubt related to business risk and financial risk for systematic and unsystematic risk.
As i know systematic risk is a broader risk which could not be diversified away but it could be hedge in other ways as compared to unsystematic risk which could be diversified away.
Business risk can be categories under systematic and unsystematic risk. However my doubt is can financial risk be categories under systematic and unsystematic risk or just under systematic risk?The financial risk (i.e. due to the level of gearing) serves to increase the existing business risk (both the systematic and unsystematic). It is not simply ‘added on’ as extra risk, but multiplies the business risk. Given well-diversified portfolios (as assumed for investors in quoted companies), it is only the systematic risk that is relevant, and where there is gearing this increases the systematic risk.
Again, I do explain this in my free lectures.
Chapters 19, 20 and 21 (and in Chapters 8 and 9 of Paper AFM given that it seems that you are studying for Paper AFM also).
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