cost of capital

Wang Securities increased its debt-to-equity (D/E) ratio from 0.65 to 0.75 due to recent bank borrowing. Let’s examine the effects on both the asset beta and the equity beta:

Asset Beta measures the risk of the company’s assets without considering its capital structure. It is a reflection of the company’s core business risk.

Equity Beta measures the risk of the company’s equity (common stock) and takes into account the company’s capital structure, including its debt. It reflects both the core business risk (as captured by the asset beta) and the financial risk arising from the company’s leverage (debt).

Now, let’s consider the effects:

1. Asset Beta (B_A): Increasing the debt level (raising the D/E ratio) often increases the financial risk of the company. As a result, the asset beta, which reflects the core business risk, is likely to remain the same or decrease slightly. The reason for this is that financial risk is being shifted to the equity holders through increased leverage, which doesn’t directly impact the core business risk.
2. Equity Beta (B_E): The equity beta takes into account both core business risk (asset beta) and financial risk due to leverage. When the D/E ratio increases, the financial risk associated with equity increases. Therefore, the equity beta is expected to rise.

Given these considerations, option B is the most accurate:

B. The asset beta will remain the same, and the equity beta will rise.

Option A is incorrect because it suggests both the asset beta and the equity beta will rise, which doesn’t align with the typical relationship between debt and asset beta.

Option C is also incorrect because it suggests that the equity beta will decline, which is unlikely when leverage increases.