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Cost of capital and capital investment decisions

Geared and ungeared betas

6.1 Two types of betas

 Ungeared ('asset') betas only incorporate systematic business risk.

 Geared ('equity') betas incorporate both systematic business risk and gearing
risk.

6.2 Estimating betas for projects (or unlisted companies)

 Many institutions calculate beta factors for listed companies by comparing
company performance with that of the stock market as a whole.

 This will typically give the company’s equity (geared) beta as it reflects all the
risks facing the shareholders, both systematic business risk and gearing risk.

 To get a project beta would involve the following steps.

1. Find a listed company with the same business activity as the project.

2. Take its equity beta and 'de-gear' it to give an asset beta.

3. Project asset beta = company asset beta as they have the same business
risk (but probably different gearing).

4. If required, 're-gear' the asset beta to incorporate project gearing to give a
project equity beta.

Note: You only need to know the concepts in P3 – the calculations
involved in de-gearing and re-gearing betas are tested in F3.

Illustrations and further practice

Now try TYU 9 – 12 in Chapter 14

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