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Chapter 6

Asset betas, equity betas and debt betas

In order to calculate cost of equity, we first need to expand our
understanding of beta factors.

The beta factor is a measure of the systematic risk of an entity relative
to the market.

This risk will be dependent on the level of business risk and the level of
financial risk (gearing) associated with an entity.

Hence, the beta factor for a geared company will be greater than the
beta factor for an equivalent ungeared company.

The relationship between the beta factors for ungeared and geared
companies is given by the following formula (given in the exam):

V E V 1 – t
D
β = β + β
a V + V 1 – t e V + V 1 – t d
E
D
E
D
Where
β e = the equity (geared) beta measures the systematic business risk
and the systematic financial risk of a company's shares

β a = the asset (ungeared) beta measures the systematic business
risk only

β d = the debt beta measures the risk associated with the debt
finance. Often we assume that debt is risk free and hence the debt
beta is zero.

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