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Dear sir, please help me to explain the question 198 of Revision kit . Question: assuming that the beta of debt is zero will understate financial risk when ungearing an equity beta.The answer is false. Thank you
In a geared company, the equity beta is higher than the asset beta because of the financial risk (the gearing).
If you look at the asset beta formula, then if the debt beta were higher then the asset beta would be higher. By assuming a debt beta of zero, the asset beta is lower than it really should be. Therefore the difference between the equity beta and the asset beta is higher than it really should be. So the financial risk is higher and is overstated.
Dear Sir, Why the difference between equity beta and the asset beta shows the financial risk?
And ungearing equity beta means zero debt ?Gearing makes equity more risky and therefore shares in a geared company have a higher beta than if there was no gearing – I explain this in my free lectures.
The asset beta (i.e. the ungeared beta) is measuring the risk of the business ignoring any financial risk due to the gearing.
You must watch my free lectures on this.
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