Cost of capital - Reading 45 Question 10

CFA Level I Corporate Finance
#1

Reading 45 - Question 10 :

Anyone can explain to me why when ratio debt to equity D/E increase, the asset beta will remain and the equity beta will rise ?

Thanks for your help.

#2

Asset Beta is a beta without any leverage. i.e. it just represents a risk without considering any equity or debt. Equity beta / project beta is an asset beta with leverage(i.e. the capital structure of a company which is essential the combination of debt and equity). So obviously, when you increase debt to equity ration it will increase your equity beta. hope this helps.

#3

thanks so much for your answer

#4

Well, asset beta is your unlevered beta - i.e. you’re removing the effects of the entity’s capital structure. As a result, raising more debt will not affect the company’s asset beta. However, the equity beta rises because you’re undertaking additional debt (equity beta DOES account for the effects of the entity’s capital structure). Hope this helps. Edit: Please ignore - someone else already addressed the question!

#5

My understanding is that asset beta does not change due to the assumption that debt beta has no market risk therefore it is = 0 (seniority claim of creditors).

#6

You should image the formular, D/E is possitive way with Equity Beta, so D/E increase (Decrease), Equity Beta increase (dcrease)