Chapter 21 - CAPM and MM combines

Question 1

What are the types of beta

Answer 1

Remember that more gearing equals more risk and therefore higher demands from shareholders so some of the types of beta are

B equity = B of shares (more risky due to gearing)

B asset = measure of risk of no gearing at all so therefore the pure business risk

B debt - B of debt (it is assumed debt is risk free and therefore is zero)

Question 2

What is the formula for combining the beta and gearing ?

Answer 2

Ba = Ve / (Ve + Vd(1-T)) x Be

Where:

Ba = Beta asset
Ve = total market value of equity
Vd = total market value of debt
Be = beta equity

Question 3

How to apply the formula ?

Answer 3

What is the business only risk for company P which has a gearing ratio of 0.4 and the beta of its shares is 1.8 (therefore we want to know what the beta asset is with gearing stripped out)

In the formula it asks for Ve and Vd which is the market value of debt and equity so if given in question (such as 5 mil debt, 2 mil equity ) then use it but there we are not given it but are given the ratio of debt to equity. Therefore for every £100 of equity there is £40 of debt totalling £140 therefore

Ba = £100 / £100 + (£40 x 0.7) x 1.8
= 1.41

Question 4

How else can you use the formula

Answer 4

You can use it within a “project specific beta”

If a company wants to branch out into a different area altogether then there will be a different risk. Only way to know risk is to look at a company within the sector to see what there risk is. Because we only want to know the risk of the business we need to strip out the gearing.

What we do is;

1. Work out the beta asset for new venture by looking at the information for a company currently within that industry
2. Once we know the beta asset of the other company we need to add in our current gearing in order to create the beta equity which is what is available to the shareholders to show how risky the business is. To do this we need to look at our companies gearing and divide by the beta asset of the other

For example if the beta asset is 1.57 for the other company and our gearing is 0.4 with tax of 25% then looking at the formula we know that

1.57 = 100 / 100 + (40x0.75) x Be

As we need Be then

1.57 = 0.76923 x Be

Be = 0.76923 / 1.57

Be = 2.04