# Equity Beta

An example from the CFAI coursework:

equity=βasset[1+((1−t

Suppose a company has an equity beta of 1.5, a debt-to-equity ratio of 0.4, and a marginal tax rate of 30 percent. Asset beta =

Beta Asset = 1.5 * [1 / 1 + ((1.0.30) * 0.40) = 1.1719

βasset=1.51+((1−0.3)(0.4))]=1.5[0.7813]=1.1719

In other words, if the company did not have any debt financing, its βasset = βequity = 1.1719; however, the use of debt financing increases its βequityfrom 1.1719 to 1.5.

My questions:

1.) The question states that without debt financing, the asset beta would = 1.1719, yet we are given a D/E ratio which shows that the company does indeed have debt outstanding. Perhaps I am misunderstanding the wording of the explanation.

2.) The question states that the equity beta is 1.5 and without debt financing, it’s 1.1719. With debt financing, the equity beta = 1.5. Why are they saying that without debt financing Beta asset = Beta equity = 1.1719 when the question states that Beta asset = 1.5? Again, I think I am misunderstanding the phrasing of the explanation.

Thanks!

βequity=1.1719[1+((1−0.3)(0.5))]=1.5821

Is fundamentally sound that similar assets should yield similar, and similar assets in similar markets should behave similar. That’s the idea of an asset beta. For example, real estate trusts encounter very defensive asset betas (0.3 - 0.5), however they assume an unlevered capital estructure. Those asset betas should be adjusted (levered) to the specific capital structure of the company or project you evaluating. That levered beta is your equity beta and must be higher than asset beta because debt increases risk.

Summing up, an equity beta assumes at least 2 types of risk: the market risk and the debt financing risk. If you add more risk, the required return must be adjusted to reflect it.

There is concept called the Pure Play Method. Read that it will help you in this matter.

We are talking about a single company here. This company can be wholely financed either through debt or through equity. But companies mostly prefer a combination of the two. If we have an equity beta, we lever it to get and asset beta. If the company has no debt outstanding, its equity beta will its asset beta too because it does not require any levering now. (Debt to Equity = 0). That’s what βasset = βequity

Suppose a company has an equity beta of 1.5, a debt-to-equity ratio of 0.4, and a marginal tax rate of 30 percent. Asset beta =

That means in this case if the comapny is not debt financed (assumption), then its Asset Beta will also be 1.5… not 1.179.

Happy to help!

Cheers