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Unformatted text preview: rest and principal), so there is less risk associated with a dollar of debt financing than a
dollar of equity financing of the same asset. So the market risk borne by the creditors is different than
the market risk borne by owners.
Let's represent the market risk of creditors as βdebt and the market risk of owners as βequity. Since the
asset's risk is shared between creditors and owners, we can represent the asset's market risk as the
weighted average of the company's debt beta, βdebt, and equity beta, βequity: ( ) ( βasset = βdebt proportion of assets + βequity proportion of assets
financed with debt
financed with equity ) βasset = βdebt ωdebt + βequity ωequity But interest on debt is deducted to arrive at taxable income, so the claim that creditors have on the
company's assets does not cost the company the full amount, but rather the after-tax claim, so the
burden of debt financing is actually less due to interest deductibility. Further, the beta of debt is generally
assumed to be zero (that is, there is no market risk associated with debt). It can then be shown that the
relation between the asset beta and the equity beta is: Capital budgeting & risk, a reading prepared by Pamela Peterson Drake 9 ⎡
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This note was uploaded on 02/07/2014 for the course MIS 304 taught by Professor Mejias during the Spring '07 term at University of Arizona- Tucson.
- Spring '07