Updated: Aug 19, 2019
In capital asset pricing model, both business and financial risk is built into the company beta. If we don't consider financial risk, we can have asset beta which we will discuss here.
ba = asset beta
βe = equity beta
βd = debt beta
Ve = market value of company’s shares
Vd = market value of company’s debt
Ve + Vd(1 – T) = after tax market value of company
T = company profit tax rate
Q: Which area of asset beta formula relevant?
A: Asset beta is relevant under business finance. It reflects business risk only as the beta value of company’s business operations without any financial risk involved.
Q: What is asset beta?
A: If a company has no debt, it has no financial risk and its beta value reflects business risk alone. The beta value of company’s business operations as a whole is called the ‘asset beta’.
Q: What is equity beta?
A: When a company takes on debt, it’s gearing increases and financial risk is added to its business risk. The ordinary shareholders of the company face an increasing level of risk as gearing increases and the return they require from the company increases to compensate for the increasing risk. This means that the beta of the company’s shares, called the equity beta, increases as gearing increases.
Q: Is asset beta increased in line with equity beta increased due to gearing is up?
A: As a company gears up, the asset beta remains constant, even though the equity beta is increasing, because the asset beta is the weighted average of the equity beta and the beta of the company’s debt.
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