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So the market risk borne by the creditors is

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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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